Cash flow of reverse convertibles, Financial Management

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(a) Let's presume that the firm may default only on last coupon payment date and that when this take place stock price would be less than some predetermined price K at the expiration date.

Cash flow of reverse convertibles would after that look like as follows.

2049_Cash flow of reverse convertibles.png

(b) We require a short position on the put option.

The give way on reverse convertibles are higher since their prices are less than a coupon bond with the same coupon payments.

(c) Firm decide to exercise the put option if stock price is less than say K. Consequently bond holders receive the stock when stocks have in fact fallen under adverse conditions. They most likely will prefer to cash in their shares which may further push down the stock prices.

(d) There is no principal guard in risky bonds. But this is dissimilar. Except the company defaults independent from the company's performance investors would get their principal. In the case of reverse convertibles nevertheless even if company doesn't default investor may suffer from substantial losses.


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