Reverse Convertibles

A reverse convertible is a structured product that generally consists of a high-yield, short-term note of the issuer that is linked to the performance of an unrelated reference asset—often a single stock but sometimes a basket of stocks, an index or some other asset. The product works like a package of financial instruments that typically has two components: a debt instrument (usually a note and often called the "wrapper") that pays an above-market coupon (on a monthly or quarterly basis); and a derivative, in the form of a put option, that gives the issuer the right to repay principal to the investor in the form of a set amount of the underlying asset, rather than cash, if the price of the underlying asset dips below a predetermined price (often referred to as the "knock-in" level).


The holder of a reverse convertible gives up the potential upside exposure to the underlying asset in exchange for an enhanced coupon. The holder of the product remains exposed to the downside exposure. The enhanced coupon of the reverse convertible is paid in any case. The coupon may be paid quarterly, semi-annually or annually. Because of this, the product will always outperform its underlying asset to the downside. The product will also outperform if the asset doesn't rise by more than the coupon. Hence, the ideal market scenario for reverse convertibles is the prospect of a sideways trending market.





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