Thursday, January 28, 2010

Convertible bond question

The Series 7 exam does not necessarily ask questions the way that you or your practice questions assumed. For example, most practice questions on convertible bonds involve the mathematical calculations and relationships involved. You finally get used to dealing with "convertible at 50" and "parity," and you start to feel confident that you're ready for questions on convertible bonds or convertible preferred stock. When you get to the exam center, however, maybe you get a fun question like this one:

When should a convertible bondholder be advised to convert her bonds to the underlying common stock?
A. when the bonds trade above parity
B. generally, under no circumstances
C. when the market for the common stock loses liquidity
D. when the bonds trade for less than the underlying stock net of commissions

See, this actually has very little to do with numbers or calculations. Suddenly you realize that all that time you spent dividing by the conversion price and figuring parity is only loosely connected to this question. In other words, welcome to the Series 7. Time to start thinking on your feet a little bit. What you have to know is that there is no reason to convert a convertible bond or preferred stock unless the prices between the convertible security and the underlying stock get "out of whack." If the bond trades at parity or above, the investor enjoys the higher market price. If the bond trades for less than the underlying stock--even after commissions paid to do the trade--investors might wish to convert to exploit the "arbitrage opportunity."


So, don't allow yourself to focus on just one narrow aspect about, for example, convertible bonds. Don't obsess over the conversion ratio and parity without also knowing that convertible bonds pay lower rates of return and are less sensitive to interest rates, etc. Calculations are not the focus of the test--being able to show your understanding of concepts is what the exam is usually after.

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