casemark/analyzing-equity-linked-instruments

Analyzing Equity Linked Instruments

Evaluates convertible bond and mandatory convertible structures with equity sensitivity, credit floor, and Greeks analysis.

When To Use

• Pricing or reviewing a new convertible bond offering (vanilla, mandatory, contingent)
• Assessing conversion economics for an existing equity-linked instrument
• Comparing convertible structures across issuers or maturities
• Modeling sensitivity of instrument value to equity price, volatility, or credit spread changes
• Evaluating investor returns under various stock-price and credit scenarios

Inputs To Gather

• Instrument terms: coupon rate, maturity, conversion price, conversion ratio, call/put provisions, reset features, contingent conversion triggers
• Issuer data: current stock price, historical and implied volatility, dividend yield, credit rating, outstanding debt structure
• Market data: risk-free rate curve, credit spread curve for issuer or comparable credits, equity borrow cost
• Structure type: vanilla convertible, mandatory convertible (PERCS, DECS, MCPS), exchangeable, contingent convertible (CoCo)
• Analysis scope: full valuation, relative value comparison, scenario analysis, or Greeks snapshot

Workflow

1. Classify the instrument

   • Identify structure type (vanilla convertible, mandatory convertible, CoCo, exchangeable)
   • Map key embedded options: equity call, issuer call, investor put, reset provisions, contingent triggers
   • Note any non-standard features (make-whole, dividend protection, change-of-control puts)

2. Decompose into components

   • Bond floor (credit component): discount contractual cash flows at the issuer's credit spread to derive straight-debt value
   • Equity option component: value the embedded conversion right using a binomial tree or Black-Scholes variant adjusted for dilution, dividends, and call features
   • For mandatory convertibles, model the capped-call / written-put payoff structure (upper and lower strike boundaries)
   • For CoCos, incorporate trigger probability modeling (mechanical vs. discretionary triggers) [VERIFY: trigger type and loss-absorption mechanism — write-down vs. conversion]

3. Calculate key metrics

   • Conversion premium: (conversion price / current stock price − 1) × 100
   • Bond floor premium: (market price / bond floor − 1) × 100
   • Investment premium: (market price / parity − 1) × 100
   • Break-even period: conversion premium ÷ (coupon yield − dividend yield on equivalent shares)
   • Parity: conversion ratio × current stock price
   • Expected yield: YTM on bond floor, current yield on convertible

4. Run Greeks and sensitivity analysis

   • Delta: sensitivity of convertible price to underlying equity moves
   • Gamma: rate of change of delta as equity moves
   • Vega: sensitivity to implied volatility changes
   • Rho (credit): sensitivity to credit spread widening/tightening
   • Theta: time decay of the embedded option
   • Produce an equity sensitivity table: convertible value at stock prices ±5%, ±10%, ±20%, ±30% from spot

5. Assess credit floor integrity

   • Verify bond floor using issuer credit spread or CDS levels [VERIFY: use issuer-specific CDS if available vs. synthetic spread]
   • Stress-test bond floor under 100bp, 200bp, and 500bp spread widening scenarios
   • Evaluate recovery assumptions if issuer is below investment grade
   • Flag instruments where parity is far below bond floor (busted convertibles) or far above (equity-like behavior)

6. Scenario and relative-value analysis

   • Model bull/base/bear equity scenarios and map convertible returns vs. straight equity and straight debt
   • Compare conversion premium, delta, and break-even across peer issuances
   • For mandatory convertibles, chart payoff profile showing capped upside and full downside participation below lower strike

7. Compile findings

   • Summarize instrument profile: equity-sensitive, balanced, or credit-sensitive positioning
   • Highlight asymmetric return features (downside protection via bond floor, upside participation via delta)
   • Note risks: call risk, credit deterioration, dividend changes, volatility crush, dilution impact on common shareholders
   • Flag any terms requiring issuer-level or regulatory verification

Output

• Instrument Summary Table: structure type, key terms, conversion metrics (premium, parity, break-even)
• Valuation Breakdown: bond floor value, equity option value, theoretical fair value vs. market price (cheap/rich indicator)
• Greeks Dashboard: delta, gamma, vega, credit rho, theta at current spot
• Equity Sensitivity Grid: convertible price and delta across a range of stock prices
• Credit Stress Table: bond floor and total value under spread-widening scenarios
• Scenario Returns Matrix: convertible total return vs. equity return under bull/base/bear
• Risk Flags: call features approaching trigger, thin bond-floor cushion, upcoming dividend changes, liquidity concerns

Quality Checks

• Confirm bond floor does not exceed market price (if it does, verify credit assumptions or flag potential arbitrage)
• Validate that delta falls between 0 and 1, and that delta + bond-floor-weight ≈ 1 for properly decomposed instruments
• Verify break-even calculation uses the correct yield advantage (coupon minus forgone dividends)
• Cross-check conversion ratio and conversion price are consistent with prospectus terms [VERIFY: confirm against offering circular or indenture]
• Ensure Greeks are internally consistent (e.g., higher delta for lower conversion premiums, gamma peak near at-the-money)
• For mandatory convertibles, confirm payoff replicates the correct collar structure (long stock + short call + long put, or equivalent)
• Mark any assumed volatility, credit spread, or dividend inputs with source and as-of date