Protecting Your Clients From Risk in Reverse Convertibles

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!