A Man for All Markets: From Las Vegas to Wall Street, How I Beat the Dealer and the Market

by Edward O. Thorp

Convertible bonds today may have complex terms and conditions. However, the basic idea is simple. Consider the hypothetical XYZ 6s of 2020. Each bond was originally sold for approximately $1,000 on July 1, 2005, to be redeemed by the company for exactly $1,000, the “face amount,” on July 1, 2020. The bond promises to pay 6 percent of the face amount in interest for each year of its life, in two semiannual installments of 3 percent, or $30, payable to holders of record on January 1 and on July 1. So far these are like the terms of a typical ordinary bond. However, the convertible has one more feature. At the option of the owner, it can be converted into twenty shares of XYZ common stock anytime until bond maturity on July 1, 2020. So this bond combines the features of both an ordinary bond and an option. The market price of the bond can be thought of as the sum of two parts. The first is the value of a comparable bond without the conversion feature, which will fluctuate with the level of interest rates and the financial soundness of the company. This sets a “floor” to the price.