Wednesday, 12 October 2011

Anatomy of a convert - Pioneers

J.J. Hill.  His company issued the first convertible.

Meyer Weinstein.   He was one of the first to hedge convertibles with other securities.  Using heuristic techniques.

E.O. Thorp.  He showed a mathematical approach to valuing a convertible as a bond converting into a warrant.

Fischer Black.  He got a CAPM-friendly solution to the pricing of a call warrant and in return got a call on the Nobel prize for economic science, but it expired just out of the money.

Since then, absolutely nothing of real importance except for a melding of credit and volatility factors into pricing models.

A lot of basics of fixed income modelling already was in place as early as 1913.  See the below book.

Anatomy of a convert - crude terms

Just as a little break form the maths I'd like to consider the major clauses in a convertible and try to come up with memorable catchphrases which describe their effect or purpose.  Some clauses in a convertible prospectus are more straight bond like (i.e. they're often seen in ordinary bonds), whereas others are more specific to the warrant/convertibility side.  Also, since traders are generally a foul-mouthed lot, I'm trying to make them as textually authentic as I can.

First up, the bond like clauses.
The holder's put clause.  "Take your shit and give me my fuckin' money".  The bond holder, on certain named dates, can decide he's had enough and would like his money back.

The  issuer's call clause. "Party's over, get out of my fuckin' house".  The issuer, if its company stock has done particularly well, can decide in short notice to force holders to decide whether or not to convert or else get their money back.

And now a couple of convertibility clauses.

The conversion right.  "First we loan you, now we own you".  The initial investment constituted an income bearing loan to the company.  The bond holder now wants to convert and own a piece of the company, since the share price now makes it desirable to own.

The reset clause.  "We sin, you win".  If the company stock price fails to perform, the bond holder is entitled to get a fatter slice of the company.

The exchangeable. "Pimpin' your daughter".  The exchange property which the issuer refers to isn't the issuer itself, but a related entity - often a majority shareholding in an asset which they now deem non-strategic.

The contingent conversion clause.  "We win, you're in".  The holder's right to convert is itself contingent on the company stock having cleared a number of performance hurdles.

The mandatory structure.  "A chattel forward".  The holder starts off lending the company capital, gets a regular income from it, then ends up getting certain ownership of the entity.