An instrument (part debt and part equity) that gives the holder the right, but not the obligation, to exchange his bond and forfeit future interest payments and redemption of principal usually at any time (i.e., American-style exercise) in return for a preset number of shares. The number of shares receivable per bond is referred to as the conversion ratio. Although no cash flow is exchanged when a convertible bond is converted into stock, the effective price at which the holder can purchase shares (the conversion price) is equal to the par value of the bond divided by the conversion ratio. For example, a bond with a par value of $1000 that can be converted into 50 shares will effectively give the holder the right to buy shares at a conversion price of $20.

A convertible can be viewed, from the perspective of an equity investor, as a combination of: equity, a put option and a swap. The put option gives the holder the right to exchange equity for a straight bond, whilst the swap to the conversion debt gives the holder bond coupons in exchange for dividends. Fixed-income investors, on the other extreme, can view a convertible as a bundle of: a straight bond and a call option. The call option allows the holder to exchange the bond for equity at a specific date (s).