Convertible Bonds: Downside Parity Floor vs. Equity Upside Participation
An investor purchases a 5% corporate convertible bond at par ($1,000) with a conversion price of $40. The underlying common stock currently trades at $35 per share. How many shares of stock does the bond convert into, and what is the bond's parity price if the common stock rises to $50?
Conversion Ratio = Par ($1,000) / Conversion Price ($40) = 25 shares. Parity Price of Bond = Stock Market Price ($50) × Conversion Ratio (25) = $1,250.
Complete Analysis & Legal Rationale
Convertible bonds offer fixed coupon income with the right to convert into common stock: (1) Conversion Ratio = Par Value ($1,000) / Conversion Price ($40) = 25 shares of common stock; (2) Parity Price of the Bond = Current Market Price of Common ($50) × Conversion Ratio (25) = $1,250. If the bond trades below $1,250 when stock is at $50, arbitrageurs buy the bond and short the stock to capture riskless profits. When stock is down, the bond acts like a straight bond, establishing a price floor.
Distractor Autopsy (Why Other Options Are Traps)
FINRA exam writers design incorrect distractors using specific calculation mistakes and regulatory misconceptions. Review why each option succeeds or fails:
Conversion Ratio = Par ($1,000) / Conversion Price ($40) = 25 shares. Parity Price of Bond = Stock Market Price ($50) × Conversion Ratio (25) = $1,250.
Fails to adhere to suitability standards regarding B.
Fails to adhere to suitability standards regarding C.
Fails to adhere to suitability standards regarding D.
Official Standard: Convertible bonds offer fixed coupon income with the right to convert into common stock: (1) Conversion Ratio = Par Value ($1,000) / Conversion Price