Chartered Financial Analyst (CFA) Practice Exam Level 2

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What defines the minimum value of a convertible bond?

The market value of the underlying equity
The maximum of Straight Value or Conversion Value
The yield to maturity of the bond
The book value of the bond

The correct answer is: The maximum of Straight Value or Conversion Value

The minimum value of a convertible bond is defined as the maximum of its Straight Value or Conversion Value. Straight Value represents the value of the bond if it were not convertible, essentially reflecting the present value of its cash flows (the coupon payments and the principal repayment at maturity) discounted at the market interest rate for similar non-convertible bonds. Conversion Value, on the other hand, indicates the value of the bond if it were converted into shares of the underlying equity, calculated by multiplying the conversion ratio by the market price of the equity. In essence, the convertible bond's value cannot fall below these two benchmarks because investors will always compare the bond's guaranteed straight value to the potential upside of converting it into equity. If the Conversion Value is lower than the Straight Value, the bondholder would prefer to hold the bond to maturity rather than convert it, ensuring that the bond's minimum value is anchored either by the linear cash flows or the potential equity conversion. Thus, the minimum value is determined by the greater of these two values, which reflects the bond's attractive features for investors in both scenarios.