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We defined the conversion premium as the difference between the market price of the convertible and the conversion value. The conversion premium ratio tells us about the magnitude of appreciation in the price that the stock should experience so that a parity price relationship is reached between the convertible bond and the underlying share. Expressed in another way, the profit/loss, if an investor buys a convertible bond, exercises it and sells the equity shares, his position should not change. That is a situation wherein the investor does not experience either profit or loss. This situation is referred to as conversion parity price relationship. The amount of appreciation that the common stock would undergo is also given by,
For the above example, this will be,
117/10 = Rs.11.70.
This ratio indicates that the price should rise by about Rs.0.70 (6.36% of 11), so that parity is reached.
In no circumstances will the market price of the convertible be lower than the conversion price because the investors may make risk-free profits through arbitrage.
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Illustration Discount bond (5 yr. bond with 10% coupon) (expected rate yield at 12%) Premium bo
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