Chapter 9 – Convertible Securities and Wall Street Innovation
Q1. Aer an initial hedge is in place, what do hedge fund investors in convertible bonds
do with shares of the underlying stock when the stock price increases or decreases?
A. When delta hedging, hedge fund investors in convertible bonds short more
Q2. True or false (and explain your answer): Convertible arbitrage hedge funds invest in
convertible bonds because the fund managers have a bullish view on the company’s
stock.
A. False: convertible arbitrage is a market neutral strategy that seeks to generate
Q3. Assume Hedge Fund A purchases a portion of Company B’s convertible and will
execute a delta hedge strategy. Describe the steps Hedge Fund A will take in the
event the price of Company B’s shares fall, and explain the reasoning behind each
action.
A. Hedge Fund A’s hedge ratio will fall with the drop in share price. Hedge Fund A
will buy shares on the open market, and deliver those shares to the parties who
Q4. If company A and B are identical in every respect except B has higher stock price
volatility, which company would likely achieve be,er convertible pricing? Assuming
convertibles issued by A and B have the same terms except for conversion price,
would the company you selected above have a higher or lower conversion price?
A. Company B – the value of the embedded option would have greater value in a
Q5. WheelCo is raising $200 million via a mandatory convertible bond issuance.
Assuming the company’s share price on the date of issuance is $20 and the
convertible bond carries a 25% conversion premium, what is the number of shares
WheelCo has to deliver to investors if its share price at maturity is (a) $19; (b) $22,
(c) $26, and (d) $30?
A. (a) 10mm; (b) 9.1mm, (c) $8mm, and (d) 8mm:
a.$19: $200 million / $20 = 10 million shares
Q6. Suppose you are a current shareholder in a company that is contemplating capital
raising alternatives. Assuming the transaction would have no negative credit
repercussions and you want minimal EPS dilution, rank the following types of
convertibles from least potential for dilution to most potential for dilution:
coupon-paying convertible, mandatory convertible, zero coupon convertible.
A. Zero coupon convertible, coupon-paying convertible, mandatory convertible.
Q7. A U.S.-based BBB-rated company is looking to make a large acquisition. Management
believes synergies from the acquisition will create new market opportunities.
Unfortunately, these new opportunities will take a few years to realize and until
then, benefit will not be fully reEected in the company’s stock price. If the company
has rating agency concerns and wants tax deductions from interest payments, what
type of security is this company likely to issue in support of its acquisition and why?
A. Unit structure mandatory convertible: Equity credit helps the company maintain
its borderline investment grade rating. Since management believes equity is
Q8. Why was the Nikkei Put Warrant program so profitable for Goldman Sachs?
A. Beyond their fees for arranging the various transactions, the put warrants were
underpriced by the Japanese insurance companies (who had a very optimistic
Q9. What is ASR an abbreviation for? Describe this transaction and the principal bene’t
for a client? What additional bene’t did IBM achieve in their ASR?
A. Accelerated Share Repurchase. This is a way for a company to receive immediate
EPS improvement through purchase of a large block of shares directly from an
investment bank that will borrow the shares from existing investors and sell them
short to the company. This reduces the denominator in EPS, leading to EPS
Q10. Assume a company’s ADTV is 240,000 shares. How many days would it take to
complete a 10.8 million share repurchase program? The company has 120 million
shares outstanding and its estimated EPS for the current ‘scal year is $3.40.
Assuming the company meets its earnings estimate, what would year-end EPS be
under an ASR program for the full 10.8 million shares, assuming it is executed 20
business days before the company’s ‘scal year end? Under an open market
repurchase program?
A. 10,800,000 / (240,000 x 0.25) = 180 days.
– ASR: 120 – 10.8 = 109.2 million shares. $3.40 * 120 million = $408 million in
–Open market: 240,000 x 0.25 x 20 =1.2 million shares. 120 – 1.2 = 118.8 million