Chartered Financial Analyst (CFA) Practice Exam Level 2

In what scenario is a convertible bond typically used?

1. To hedge against currency risk

2. To gain equity participation through conversion to common shares

3. To secure loans with collateral

4. To create a fixed income stream while avoiding interest rate risk

The correct answer is: To gain equity participation through conversion to common shares

A convertible bond is typically utilized to gain equity participation through conversion to common shares. This financial instrument offers bondholders the option to convert their bonds into a predetermined number of shares of the issuing company’s common stock, usually at specific times during the bond's life. This feature is particularly appealing in scenarios where the company’s stock is expected to appreciate significantly, allowing bondholders to benefit from potential upside while still receiving interest payments during the bond's term. The equity participation aspect distinguishes convertible bonds from traditional bonds, as investors are not only receiving fixed income but also have the opportunity to capitalize on the company's growth. This dual nature - providing fixed income and the possibility of capital appreciation - makes convertible bonds an attractive investment for those seeking balance between risk and return. Other scenarios listed, such as hedging against currency risk or securing loans with collateral, don’t align with the primary purpose of convertible bonds, which centers on equity participation. Additionally, while convertible bonds do provide a form of income, they do not inherently avoid interest rate risk; they carry interest rate implications like other fixed-income securities.