Convertible bonds are typically embedded with specific types of derivatives (call, put, and swap). From an equity investor’s perspective, a convertible is a combination of equity, a put option, and a dividend swap. A convertible gives allows its holder to control a specific number of common shares (hence the holder owns “parity”). If the underlying stock price falls, the holder could refrain from conversion and chooses, instead, to receive a cash redemption amount at maturity. The right not to convert is equivalent to a put option. The holder will only exercise this right if the redemption value is higher than parity.

Moreover, the holder indirectly owns a specific number of common shares, but receives coupons until either conversion (on which coupon payments cease to be made, and dividends are paid instead) or maturity. This is equivalent to having a long position in a dividend swap that allows the equity holder to receive fixed payments (the coupons) in exchange for dividends.

From the viewpoint of a fixed income investor a convertible is a combination of a straight bond with a call option. The holder owns a straight bond that pays coupons and a cash redemption value at maturity. The value of this bond is the bond floor. Additionally, the holder has the right to convert his bond into a preset number of common shares, at any time before maturity. This right is equivalent to having a long position in a call option that allows the holder to acquire shares on conversion. At maturity date, this option call has a strike price equal to the conversion price. However, unlike an ordinary option, this option makes no cash payment on exercise.