CFA Level IFixed IncomeMedium
A convertible bond has a par value of $1,000 and a conversion ratio of 25 shares. The bond currently trades at $1,100, and the underlying common stock trades at $42 per share. The bond's conversion premium, in dollars, is closest to:
- A$1,050
- B$0
- C$42
- D$50
Show answer & explanationAnswer & explanation
Correct answer: D. $50
Conversion value = 25 shares × $42 = $1,050. Conversion premium = market price of bond − conversion value = $1,100 − $1,050 = $50.
Why the other options are wrong
- A. This is the conversion value, not the premium.
- B. Would imply the bond trades exactly at its conversion value, which is not the case here.
- C. Equals the stock price, not the premium over conversion value.
Conversion Premium
The amount by which a convertible bond's market price exceeds its conversion value (the value if immediately converted into shares).
- Conversion value = conversion ratio × current stock price
- Premium reflects the value of the option to convert later at a potentially higher stock price
- Premium tends to shrink as the stock price rises well above the conversion price
Memory trick: 'Bond price minus stock-swap value equals the premium you're paying for optionality'