Enhanced optionality

Chooser convertibles are a relatively recent and rarely used innovation, but in essence are simply bonds with a “best of” option to convert into a number of different underlying equities. The first of these issues – the Swiss Re triple – gave investors the right to convert into shares of Swiss Re itself, or into shares of either Credit Swiss or Novartis according to the investor’s choice. This structure obviously gives greater value to investors than a plain vanilla Swiss Re convertible (with all other terms being equal) or, indeed, an exchangeable into either of the two other stocks. Some outright accounts have viewed this bond as an excellent play on the Swiss market, on the grounds that at least one of the underlying stocks would outperform the index. However, because at the time the bond is sold it is impossible for investors to know which particular underlying share – if any – will provide the optimal conversion, this instrument is not popular with outright “stock-picking” investors and these investors never seem to fully appreciate the value of the additional optionality. Indeed, part of this relates to problems with modelling chooser convertibles. Chooser options themselves are well-understood exotic options, but are usually a European exercise and therefore modelled as such. Chooser convertibles need to be modelled as US options and have far greater path dependency and, unfortunately, few convertible models have this type of chooser functionality built in. Consequently, few investors are able to accurately evaluate these bonds, which affects the market price even for those that can. As only a small number of chooser bonds have been issued, many investors have not developed the required additional functionality within their models, but simply allow a small amount of additional implied volatility to result from the enhanced optionality. Opportunity and pricing From the company’s perspective, the advantages of selling a chooser option simply boil down to opportunity and pricing. For an issuer with relatively large stakes in a number of different companies, happy to sell part of any of these stakes, issuing a chooser effectively has minimal cost, as the issuer is indifferent as to which stock the investor converts into. However, even though many participants in the market do not fully evaluate the enhanced optionality, investors do recognise that there is additional value and this allows tighter terms and, therefore, cheaper financing, even though they probably do not fully account for the value of the chooser option. Chooser convertibles have the same accounting treatment as exchangeables and under US Generally Accepted Accounting Principles, the bond will be bifurcated – split into bond and option components – with the option component then “marked to market” through the issuer’s P&L (profit and loss). However, depending on the correlation of the underlying shares, a chooser option may have lower volatility than a single stock option, reducing the volatility of the bond’s P&L impact.