1 - When is the best time to invest in reverse convertibles?
Given the structure of reverse convertibles, the maximum earnings that an investor can obtain are realised if the value of the underlying security does not decrease below the value of the strike price during the life of the reverse convertible. For this reason, assuming that the value of the underlying upon subscription is approximately equal to the reference price, those purchasing the
reverse convertible believes that the price of the underlying share will remain substantially stable or at the most will slightly increase. Therefore, investors expecting a sharp increase in the underlying security may be more interested in directly purchasing the shares because the maximum profit deriving from the purchase of the reverse convertible cannot in any case exceed the amount of
the coupon, whose value is predetermined.
The typical buyer of a reverse convertible is an investor that is counting on the stability of the underlying share, believing that the value of the share will neither increase nor decrease very much during the life of the reverse convertible.
2 - If I have to disinvest part of my equity to buy a reverse convertible, what should I sell?
Investing in reverse convertibles may potentially lead to the loss of the entire principal invested (with the exception of the coupon interest which is paid in any event). Thus, reverse convertibles should represent a minimum portion of the capital in the portfolio of a small investor, and should not substitute traditional bonds. Instead, an investment in reverse convertibles may be a good
alternative to shares when there are no specific expectations that the market will rise, as it may be more suitable for those who expect sharp increases in the underlying security to directly purchase the shares, because the profit deriving from the purchase of reverse convertibles may in no case exceed the amount of the coupon, whose value is predetermined.
3 - If I have a share in my portfolio, and buy a reverse convertible on the same share, does this reduce my risk?
No, it increases risk because both yields depend on the performance of the same share. For example, if, at maturity of the reverse convertible, the share lost 50%, the investor who purchased the share and the reverse convertible would lose principal amounting to:
- 50% of the share;
- 50% of the reverse convertible;
while the investor would earn only the coupon interest of the reverse convertible. Consequently, the investor’s equity would be almost halved.
4 - Are reverse convertibles suitable securities for speculative activity?
No. Reverse convertibles are short-term securities (with maturities of normally less than one year) and are not listed on the official market. Thus, they are not suitable for trading operations (repeated purchase and resale on the market prior to maturity). Investors purchasing reverse convertibles should accept carrying the investment to term.
5 - Who must I contact to sell the reverse convertible prior to maturity? And can the price offered me be considered fair?
Given that reverse convertibles cannot be listed on the stock exchange, in order to sell them prior to maturity, you must check whether they are traded on an alternative trading system (ATS), or turn to your bank.
The price that the bank offers, normally determined on the basis of the issuer’s indications (if the bank is not the issuer), cannot be easily valued by a non-professional investor. Moreover, this price contains a fee for the intermediary, as in any case of intermediation.
We have said that an investment in reverse convertibles is equivalent to the purchase of a bond and the sale of a put option to the issuer, whose premium is "collected" in the form of very high coupon interest. Thus, the value of a reverse convertible can decrease either following a decrease in the value of the bond component or due to an increase in the value of the put option.
The value of a fixed-rate bond decreases when interest rates increase. On the contrary, the value of the put option increases as the price of the underlying decreases. (In effect, there are other factors that influence the value. For these factors, refer to the guide to covered warrants; however, in reading those indications, keep in mind the fact that the investor is selling an
option).
In our case, it is highly unlikely that the value of the bond will decrease, given that the short term and the significantly higher coupon compared to market rates render it insensitive to changes in interest rates. However, the put option may increase its value as a result of the factors which determine its price, which include a decrease in the price of the underlying. It is important to
note that the investor should also collect the accruals of the large coupon provided for by the regulations of the reverse convertible.
Thus, the only casein which the issuer may reimburse less than the amount invested is a significant increase in value of the derivative component, which even compensates for the value of the accruals that the investor should receive.
The following table (which does not take into consideration the accruals), provides approximate, but on the whole effective, indications for understanding the congruity of the price of the reverse convertible offered by the purchaser, starting from the subscription price. In fact, if:
|
Price of underlying upon sale, compared to price of underlying upon subscription
|
Value of the Put Option
|
Value of the Reverse Convertible
|
|
HIGHER
|
LOWER
|
HIGHER
|
|
LOWER
|
HIGHER
|
LOWER
|
|
THE SAME
|
LOWER
|
HIGHER
|
