Legal Definitions - conversion premium

The term conversion premium refers to the additional amount an investor pays for a convertible security (like a convertible bond or convertible preferred stock) above the immediate value of the common stock they would receive if they converted it right away. Essentially, it's the market's valuation of the future option to convert, along with other benefits such as income generation or downside protection offered by the convertible security itself.

• Example 1: Convertible Bond in a Growing Company

  Imagine "Tech Innovations Inc." issues a convertible bond that allows the holder to convert it into 50 shares of the company's common stock. Currently, Tech Innovations' common stock is trading at $25 per share. If an investor were to convert the bond immediately, the common stock received would be worth 50 shares * $25/share = $1,250. However, the convertible bond itself is trading in the market for $1,350. The conversion premium in this scenario is $1,350 (bond price) - $1,250 (immediate conversion value) = $100. This $100 premium reflects the value investors place on the bond's fixed interest payments, its relative safety compared to common stock, and the potential for Tech Innovations' stock price to grow significantly in the future, making the conversion option more valuable over time.

• Example 2: Convertible Preferred Stock with Dividend Income

  "Green Energy Solutions Corp." has issued convertible preferred stock, where each share can be converted into 10 shares of the company's common stock. The common stock is currently trading at $18 per share. If an investor converted one share of preferred stock immediately, they would receive common stock worth 10 shares * $18/share = $180. However, the convertible preferred stock is currently trading at $195 per share. The conversion premium here is $195 (preferred stock price) - $180 (immediate conversion value) = $15. This $15 premium accounts for the preferred stock's consistent dividend payments, its priority over common stock in receiving dividends and in liquidation, and the potential for the common stock to appreciate, offering a future upside.

• Example 3: Market Optimism for Future Growth

  Consider "BioPharma Breakthroughs Inc.," a company with a promising new drug in clinical trials. They have convertible bonds that can be converted into common stock at an effective price of $60 per share. Currently, BioPharma's common stock is trading at $55 per share. If an investor converted a bond immediately, the common stock received would be worth less than the bond's face value. Let's say the bond is trading at $1,100, and its immediate conversion value is $1,000 (based on 20 shares * $50/share, assuming a conversion ratio of 20 shares per bond). The conversion premium is $1,100 (bond price) - $1,000 (immediate conversion value) = $100. Even though the common stock is currently trading below the conversion price, the bond still commands a significant premium. This premium reflects strong market optimism about the success of the new drug, anticipating that the common stock price will eventually surpass $60, making the conversion option highly valuable. Investors are willing to pay extra for this potential upside, combined with the security of the bond's fixed interest payments while they wait.