. 31
( 60 .)



Cash flow types Credit ratings

FIGURE 4.20 Mapping process.

of the callables is a 10-noncall-2, but each has a different status with regard
to the relationship between F and K. Namely, one has F K, the other has
F much greater than K (deep in-the-money), and the last has F much less than
K (deep out-of-the-money). The price volatility of an at-the-money 10-non-
call-2 is the same as that for a generic double-A-rated corporate security.
Accordingly, with all the shortcomings and limitations that a mapping
process represents, it would appear that such a process might be used to find
connectors between things like credit profiles and cash flow compositions.
The particular relationship highlighted in the figure might be of special inter-
est to an investor looking for an additional and creative way to identify value
across various financial considerations inclusive of credit and structure types.
Parenthetically, a financing market exists for MBS securities as well. An
exchange of an MBS for a loan of cash is referred to as a dollar roll. A dol-
lar roll works very much like the securities lending example described ear-
lier in this chapter, though obviously there are special accommodations for
the unique coupon and price risk inherent in an MBS as opposed to a generic
Treasury Bond.
A preferred stock is a security that combines characteristics of both
bonds and equities (see Figure 4.21). Like bonds, a preferred stock usually
has a predetermined maturity date, pays regular dividends, and does not
convey voting rights. Like an equity, a preferred stock ranks rather low in

Financial Engineering

= Preferred stock
Convertible structuure



FIGURE 4.21 Use of spot and options to create a convertible.

priority in the event of a default, but typically it ranks above common stock.
The hybrid nature of preferred stock is supported by the fact that while
some investment banks and investors warehouse these securities in their
fixed income business, others manage them in their equity business.
One special type of preferred stock is known as a convertible. As the
name suggests, the security can be converted from a preferred stock prod-
uct into something else at the choice of the investor. The “something else”
is usually shares of stock in the company that originally issued the preferred
stock. A convertible typically is structured such that it is convertible at any
time, the conversion right is held by the investor in the convertible, and the
convertible sells at a premium to the underlying security. Investors accept
the premium since convertibles tend to pay coupons that are much higher
than the dividends of the underlying common stock.
Generally speaking, as the underlying common stock of a convertible
declines, the convertible will trade more like a bond than an equity. That is,
the price of the convertible will be more sensitive to changes in interest rates
than to changes in the price of the underlying common stock. However, as
the underlying stock price appreciates, the convertible will increasingly
trade much more in-line with the price behavior of the underlying equity than
with changes in interest rates.
Figure 4.22 shows a preferred stock™s potential evolution from more of
a bond product into more of an equity product.
A convertible™s increasingly equitylike behavior is entirely consistent with
the way a standard equity option would trade. That is, as the option trades
more and more in-the-money, the more its price behavior moves into lock-
step with the price behavior of the underlying equity™s forward or spot price.
Parenthetically, an option that can be exercised at any time is called an
American option, while an option that can be exercised only at expiration is
called a European option. In the case of a European option type structure, if
the underlying equity price is above the convertible-equity conversion price


as the convertible comes to maturity, then the conversion should be made;
the option to receive equity in exchange for the convertible ought to be exer-
cised. But if the underlying equity price is below the applicable conversion
price, conversion should not be made; an investor is better off with taking
the redemption value of the convertible.
To add another twist to this scenario, convertibles also can be issued
with callable features. A callable feature entitles the issuer to force a given
security into an early redemption. Thus, depending on its precise charac-
teristics, the correct valuation of a convertible can be a complex undertak-
The cash flow triangle shows how the price behavior of an in-the-money
preferred stock can be seen as more spot- or forward-like, as well as more
equity- or bond-like (see Figure 4.23).
The answer to the question of “What really is a convertible?” can very
much depend on the particular time in the life of the convertible when the
question is being posed. An understanding and appreciation of the factors
driving the convertible around the triangle (pun very much intended) will
greatly facilitate an investor™s assessment of relative value and opportunity.
There are a few different ways to creatively influence the credit quality
of a bond as illustrated by Figures 4.24 and 4.25. Within the world of fixed
income, there are bonds with short call options embedded in them (callables)
and bonds with long puts embedded in them (putables). Chapter 2 explained
that a put option is generally thought of as providing downside price pro-
tection; as price falls, the value of a put option rises. Concomitantly, a credit
call option suggests there is downside protection against the risks typically
associated with a deteriorating credit story. These risks might include price-
related dynamics as the market adjusts itself to a less favorable credit envi-
ronment. Being long a credit call option will not prevent a credit rating
agency from placing a company on credit watch or downgrading a company
outright, but being long a credit call option might help to ameliorate the
adverse price consequences typically associated with negative credit events.

More like an bond More like an equity

Gray Area
Underlying stock Underlying stock
price moves lower price moves higher

FIGURE 4.22 Transformation scenarios for a convertible bond.

Financial Engineering

Spot Forward
Equity Equity

Spot bond

• A convertible preferred security is a combination of a bond and an embedded
long call option on an equity.
• A convertible that trades increasingly in-the-money (above its conversion value)
and is immediately exercisable (American style) is increasingly likely to mirror the
price behavior of the underlying equity™s spot price.
• A convertible that trades increasingly in-the-money and is not immediately
exercisable (European style) is more likely to mirror the price behavior of the
underlying equity™s relevant forward price.
• For convertibles that may embody more than one optionlike feature (as with a
callable provision along the lines of the previous section), a more detailed
evaluation of respective option contributions would be appropriate.
• A convertible that trades increasingly out-of-the-money (below its conversion
value) is increasingly likely to mirror the price behavior of a debt instrument of the
underlying issuer (and as such be designated as a busted convert).

FIGURE 4.23 Cash flow triangle.

= Credit-enhanced bond

Bond put


FIGURE 4.24 Use of spot and options to create a credit-enhanced bond.

As previously stated, a putable bond is composed of a bond and a long
put option. The put option is most commonly viewed as being a put option
on price; that is, if interest rates rise, causing price to fall, the put option
presumably takes on value since it provides a support or floor level for prices.


= Credit-enhanced bond
Spot Forward
Bond Currency

FIGURE 4.25 Use of spot and forwards to create a credit-enhanced bond.

A putable bond differs from a callable bond in at least two fundamental

1. With a putable bond, the embedded put is a long embedded put, and
with a callable bond, the embedded call is a short embedded call.
2. As a direct consequence of number 1, the combination of being long a
bond and long a put option, as with a putable bond, results in a payoff
profile that much resembles a synthetic long call, while the combination
of being long a bond and short a call option, as with a callable bond,
results in a payoff profile that much resembles a synthetic short put.

The combination of a long call and a short put results in a payoff profile
resembling a simple long position in a forward. The diagrams in Figure 4.26
show these various relationships.
All else being equal, except for being defensive on the market, put-call
parity and efficient markets would suggest that we would be indifferent
between the callable and the putable. That is, being short an embedded call
or being long an embedded put are defensive or bearish strategies. However,
if all else were not equal, and if credit risk were a particular matter of con-
cern, then the put bond would take on a greater value relative to the callable.
Since the putable bond has a payoff profile of a synthetic long call, down-
side price risk is limited while upside price potential is unlimited. If an
adverse credit event were to occur, the putable bond still would provide price
support on the downside.
The rationale for this downside support is simply that covenants for
putable bonds (indeed, all covenants that this author is aware of) tend not
to make any stipulations about the price support features of the put regard-
ing segmenting market-related phenomena (as with changes in interest rates)
versus any other phenomena (as with changes in credit risk). Accordingly,
the put option embedded in a putable bond de facto provides a level of price
support for any event that might otherwise push the price of a bond lower.
This contrasts with a callable bond, where with its synthetic short put pro-

Financial Engineering

a b c


. 31
( 60 .)