Conversion Value
The decision to convert a bond will depend on its conversion value and the current market value of the bond. The conversion value, which is the bond’s value if it were to be converted at the present moment, is the conversion ratio times the current market price of the stock. Suppose a convertible bond has a conversion ratio of 50 and the issuer’s stock is currently selling at $24. The conversion value of the bond is 50 x $24 = $1,200. If the bond happens to be selling at $1,200, it is said to be at conversion parity.
A price of a convertible bond will never vary far from its conversion parity, because if it did, many investors would try to profit from the difference between a bond’s conversion value and its selling price. This investing strategy of profiting from differences in prices across markets is called arbitrage. To illustrate, suppose a convertible bond has a conversion value of $1,200, but is selling at $1,160. An arbitrageur (a fancy word for an investor who wants to take advantage of this difference) purchases the bond and immediately converts it, making a risk-free $40 profit. Because there are always arbitrageurs that will make a profit by doing this in quantity, bond prices never vary far from parity.
Example Question 1
A customer