Conversions in Finance: What It Is, How It Works, and Examples
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Summary:
Explore the intricacies of conversions in the finance industry—a process where one type of asset transforms into another at a predetermined price. This comprehensive guide delves into the essential aspects of conversions, shedding light on their significance and impact on securities like convertible bonds and preferred shares.
Understanding conversions
A conversion, in financial terms, refers to the exchange of a convertible asset into another type, typically at a predetermined price and before a set date. The conversion feature, a financial derivative instrument, holds distinct value from the underlying security, contributing to the overall worth of the asset.
Key aspects of conversions
The conversion process is exemplified by convertible bonds, where bondholders possess the option to exchange the bond for a predetermined amount of the bond issuer’s equity. This conversion is strategically exercised when the value of the resulting shares surpasses the bond’s original worth.
Consider Jill, holding a convertible bond worth $1,000 from XYZ Corp. She would likely exercise the conversion option only when XYZ’s share price exceeds $10, adhering to the conversion ratio outlined in the trust indenture at the time of issuance.
Another financial instrument incorporating a conversion feature is preferred shares. Shareholders with conversion rights can convert preferred shares to common shares if it proves advantageous. The conversion ratio, disclosed in the share prospectus, dictates the number of common shares resulting from the conversion.
For example, Jane purchases preferred stock for $100 with a conversion ratio of four. This implies she can convert one preferred share for four common shares, with a conversion price of $25. Jane might exercise her conversion option if the common shares’ price rises above $25.
Frequently asked questions
What is the conversion feature?
The conversion feature is a financial derivative instrument allowing the exchange of a convertible asset into another type at a predetermined price.
How does conversion affect existing shareholders?
Converting preferred stock into common stock dilutes the percentage ownership of existing common shareholders, impacting fundamental positions like ownership percentage, voting control, and EPS.
Who decides when conversion occurs?
In most cases, the holder of a security with a conversion feature determines whether and when to convert. However, in some cases, the company retains the right to decide when the conversion occurs.
What factors should investors consider before opting for conversion?
Investors should weigh the potential benefits, including enhanced security value and flexibility, against the drawbacks such as dilution of ownership and potential market confusion.
How is the conversion ratio determined?
The conversion ratio, outlining the number of common shares resulting from the conversion, is usually disclosed in the trust indenture for convertible bonds or in the share prospectus for preferred shares at the time of issuance.
Can conversion negatively impact a company’s existing common shareholders?
Yes, converting preferred stock into common stock can dilute the ownership percentage of existing common shareholders, impacting fundamental positions like voting control, EPS, and overall shareholder value.
Key takeaways
- Conversions involve exchanging a convertible asset into another type at a predetermined price.
- Convertible bonds and preferred shares are examples of assets that can undergo conversions.
- The conversion feature adds value to the overall worth of the security.
- Investors should weigh the pros and cons before opting for conversion.
- Converting preferred stock into common stock may dilute existing shareholders’ ownership and impact fundamental positions.
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