Convertible Stock

Convertible stock is generally called as convertible preferred stock. Convertible stock is a type of preferred stock which has the option of being converted into common shares which is issued by the same firm. Some of the preferred stock is convertible into the common stock of the issuer. The conversion feature grants the preferred shareholder the right to convert a share of preferred stock into a predetermined amount of common stock of the issuer. A convertible preferred stock is preferred stock with an embedded call option on the common stock.  However, most of the convertible preferred stock issues are also callable which, in essence, allows the issuer to force the preferred shareholders to either convert their preferred stock into common stock or redeem shares for cash.

To understand the preferred stockholder’s decision when their shares are called, we must define some terms. First, the preferred stock’s conversion value is the number of common shares into which one share of a preferred stock could be converted multiplied by the current share of the common stock. Second, the effective call price is the sum of the nominal call price applicable at the time of the call plus any accrued dividends. Given this backdrop, if a convertible issue is called, the preferred shareholder’s decision is generally straightforward. If the effective call price is greater than the conversion value, the preferred shareholder will surrender the security in exchange for its redemption value.  If the conversion value is greater than the effective call price, the preferred shareholder will convert the shares into common stock. Firms usually call preferred issues when they are “in the money” (i.e., the conversion value exceeds the call price). Thus, a call of an “in-the-money” preferred stock is known as a conversion forcing call.

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