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Definition: Conversion Premium
The price of a convertible security is generally higher than the current market value of the common stock in which it has to be converted. Therefore conversion premium may be defined as the amount by which the price of a convertible security is above the current market value of the common stock into which it may be converted.
A conversion premium is mostly expressed in monetary terms and represents the difference between the price of the convertible and the higher of the conversion or straight-bond values. Convertibles are generally securities, for example bonds and preferred shares which can be exchanged in returned for a specific number of another form (generally common shares) at a price which has been previously agreed-upon. If the investor is willing or if the issuing company forces the conversion only then can the convertibles be converted.
Almost all convertible securities would trade at a conversion premium, though what happens is, it normally decreases as the common stock increases in price. For example, a bond trading at Rs 1,500 and convertible into 50 shares of common stock with a current market price of Rs 20 each sells at a conversion premium of Rs 1,500 - (50 × Rs 20), or Rs 500.
Convertible bonds, which may simply be called converts, are generally debentures, which can be assumed to be unsecured bonds that can be converted into common stock of the issuer, a corporate, within a predetermined time period as and when the investor wishes. Either the number of shares or the share price would be specifically written in the indenture. Conversion ratio is the number of shares of stock that each bond can be converted into. Thus, a bond which can be converted into 10 shares of stock will have a conversion ratio of 10 to 1, or simply 10.
Other than calculating the profit or loss on a certain conversion, calculating the conversion premium will also determine if it is a good or a bad time to convert one’s convertible securities. As a matter of fact, if the common stock’s current market value is less than the value that shall be received upon converting the convertible security, the best decision for the investor would be to do nothing. On the other hand, if the investor chooses to convert his securities into stock then, he would be losing both, his valuable time and money.