Conversion of a Financial Asset - Explained
What is Converting a Security?
Written by J. Mance Gordon
Updated at April 20th, 2024
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What is Conversion of a Financial Security?
Conversion is exchanging an asset that has a conversion feature into a different kind of asset at a previously agreed price on or before a previously agreed date. This feature is a differently valued financial derivative instrument from the underlying security, and thus an implanted conversion feature contributes to the total value of the security.
How does Conversion of a Financial Asset Work?
An asset such as a convertible bond can be converted. This bond provides the holder with the choice of exchanging it for an amount of the bond issuer's equity which was previously determined. The bondholder usually applies the choice if the value of the shares to be received from this conversion rises beyond the bond's worth. For a convertible bond, the conversion price or ratio listed in the trust indenture during the bond's issue. Preferred shares also have a conversion feature.
Shareholders have conversion rights which enable them to exchange preferred shares into common shares if it will be beneficial. At the time of issue, the shareholders are provided with a prospectus which details the conversion ratio.
For example, if one buys a preferred stock for $100 and it has conversion ratio of 4, it means that they can convert one preferred share for 4 ordinary shares. The conversion price will, therefore, be $100/4 = $25. An individual will consider using the conversion option if the price of the common shares goes above $25.
Usually, the individual holding the convertible security decides when and if to convert but in some cases, the corporation has a right to determine when this will happen. Exchanging preferred stock to common stock reduces the ownership percentage of the common shareholders. When the convertible securities are exchanged into newly issued stock, the total shares increase in the market and consequently the shareholders ownership of a company reduces. This shares dilution leads to a significant change in stock positions such as voting control, earnings per share and the value of shares.