May 6, 2013

Protecting Your Clients From Risk in Reverse Convertibles

In a recent post I mentioned that I was buying reverse convertibles to capture yield. Of course the question of risk arose—What happens if the price of the stock falls below its buffer?

Unfortunately, it happened. In fact, it landed about 10% below the buffer price. One positive here is that the term of this particular issue has another four and a half months until maturity.

I am hopeful the price of the stock will finish above the starting price, in which case, the client will receive the full principle back at maturity. However, even if the stock's price does not finish above its strike price, as long as it's close, and since the client will receive shares of stock in lieu of principle, if the loss is small enough, it may be offset to some degree, or fully, due to the 18.65% rate of interest this particular issue is paying.

That said, for future investments in this type of vehicle, I came up with a a way to protect the client against this risk. If you are buying or considering investing in reverse convertibles, you'll want to tune in. If you are not familiar with how these investments work, you should read my post from Feb. 11 on the subject.

Here's how the protection works. At the time of issue, let's assume you invest $10,000 in a reverse convertible and the underlying stock has a price per share of $20. Hence, at the time of issue your $10,000 investment would be equivalent to 500 shares of the stock. To protect your investment, you would buy a put option. In essence you would buy five option contracts since each contract is equal to 100 shares. If the stock price declined and your option was "in the money," and especially if it fell as far as the buffer price, you would exercise the option, and the client would be made whole. Conversely, if the stock price rose, the reverse convertible would not need protection. Hence, if the stock price remained above the buffer price during the term, then at maturity, the client would receive their initial investment.

Of course, there is always the possibility that the stock price could fall, but not breach the buffer, and the put option could be in the money. Then, the client could exercise the option and suffer no loss. Again, if the put option was never exercised, the client would be out his premium, but the cost of the premium would be offset by the interest on the investment.

For this to be viable, the cost of the option premium would need to be much less than the interest earned on the investment. In fact, if it were possible for the issuing bank to incorporate this into their reverse convertible offerings, I expect they could corner the market, as it would be a riskless, high interest investment vehicle.

Have a great week and thanks for reading!

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