Reverse convertible securities

These are short-term coupon bearing notes, which are designed to provide an enhanced yield while maintaining certain equity-like risks. Their investment value is derived from the underlying equity exposure, paid in the form of fixed coupons. Owners receive full principal back at maturity if the Knock-in Level is not breached (which is typically 70-80% of the initial reference price). If the underlying stock falls in value, the investor will receive shares of stock which will be worth less than his original investment. The underlying stock, index or basket of equities is defined as Reference Shares. In most cases, Reverse convertibles are linked to a single stock.

You may also find inverse reverse convertibles, which are the opposite of a reverse convertible. The owner benefits as long the underlying stock does not go above a predetermined barrier. If the underlying stock breaches the barrier, the owner will receive the principal minus the percentage of the movement against him.

These are both types of structured products, which are sophisticated instruments and carry a significant risk of loss of capital.[2]

In a low interest rate and high market volatility environment, reverse convertibles are popular as they provide much enhanced yield for the investors. By receiving enhanced coupons, investors take on the risk of losing part of the capital. Prior to the turn of the millennium (2000), reverse convertibles mostly consisted of investors shorting standard at-the-money (ATM) put options. Investors would lose capital if at maturity the underlying fell below the initial level. To increase the protection for investors, barrier reverse convertibles were introduced whereby investors were instead shorting ATM down-and-in put options. The additional barrier event increased the protection for the investors, as the put option would not come into effect unless the (down) barrier was hit. The barrier protection feature triggered much increased reverse convertible issuances in UK in the early 2000s as well as in the European retail markets. By the early 2010s, the (barrier) reverse convertibles were also among the most popular structured products in US.

While the barrier protection feature was beneficial for investors, for the issuers, managing and hedging relatively long-dated (e.g. 3~5 years) equity barrier risks were a serious challenge. The hedging parameters (Greeks) near the barrier could be unstable, and they could suddenly change which would lead to a massive increase in trading volumes in the process of hedging. In contrast to FX underlyings, equity underlyings for the reverse convertibles tend to have much less liquidity. The problems would become more severe as and when the products were introduced to the mass retail market. To solve these practical problems during the product design process, various technologies [3] were adopted in the barrier reverse convertible pricing models to deal with barrier concentration risks. Reverse convertibles nowadays account for a large portion the structured products issued for retail and private investors. The issuances of other breeds of reverse convertibles, such as those combining a callable payoff, or a knockout clause, have also increased substantially [4] with the ever changing market conditions.

• Underlying stocks or basket of equities may include names such as:
  • Dell
  • Wal-Mart
  • Exxon Mobil
  • Cisco
  • Best Buy
  • Corning
• Broad market indices may include names such as:
  • RSI Diversified Index
  • S&P-500 Index
  • EURO STOXX-50 Index
  • FTSE-100 Index
  • NIKKEI-225
  • Nasdaq-100 Index

They are short-term investments, typically with a one-year maturity. At maturity, the owner receives either 100% of their original investment or a predetermined number of shares of the underlying stock, in addition to the stated coupon payment. The owner's earning potential is limited to the security's stated coupon, because he receives coupon payments regardless of the performance of the underlying reference shares. Risk potential is the same as for the underlying security, less the coupon payment.

Coupon payments are the obligation of the issuer and are paid on a monthly or quarterly basis. These instruments are sold by prospectus or offering circular, and prices on these notes are updated intra day to reflect the activity of the underlying equity. The rule of thumb is: The higher the coupon payment, the greater likelihood of receiving stock at maturity.

Note: Coupon rate is determined by issuer. Sometimes holders do expect zero coupon bond like reverse convertible bonds.

At maturity, there are two possible outcomes:

• Cash Delivery: If the stock closes at or above the initial share price upon valuation date, regardless of whether the stock closed below the knock-in level during the holding period, or if the stock closes below the initial share price, but has never closed below the knock-in level.
• Physical Delivery: If the underlying shares closed below the knock-in level at any time during the holding period and does not trade back up above the initial share price on valuation date (four days prior to maturity).

The initial share price is determined on the trade date. The final valuation of the shares is based on the closing price of the reference shares determined four days prior to maturity. If the investor is delivered physical shares, their value will be less than the initial investment.

They trade flat and accrue on a 30/360 or actual/365 basis. End of day pricing is posted on Bloomberg L.P. and/or the internet. Pricing fluctuates intraday. Reverse Convertibles are registered with the U.S. Securities and Exchange Commission (SEC).