Perhaps a more intuitive way of thinking about the conversion pre-
mium is to break it down into its constituent pieces. We have done this
in the equation below:
This shows the value of the bond to the investor can be thought of in
terms of what is received, that is the coupon, but the dividend is for-
gone, because we have not yet converted, that is why it is subtracted
in the equation. The other piece is the value of the embedded option.
The clearest way of illustrating how these components change with
share price is with reference to Figure 1.20.
We can see from this chart that there are two main regions. We have
the region to the right where the bond follows the share price and
is said to be ‘in the money’. The premium in this region is very small
because there is no longer any upside potential within the bond. The
region to the left is where the current share price is below the conver-
sion value and here the premium will be appreciable in anticipation of
the share price rising.
1.7 Asset-backed securities
These are ﬁxed income instruments which have speciﬁc ﬁnancial
resources pledged as collateral to pay the interest and redemption.
These resources should be looked upon as a pooling arrangement
rather than a one to one matching with the so-called asset backing
to the resulting instruments.
The backing can consist of many different types of receivables.
Commonly encountered are mortgages, consumer loans, credit card
receivables and commercial loans. In common with much ﬁnancial
architecture the phenomenon of asset-backed securities was introduced
Conversion premium option value coupon dividend.
26 Credit risk: from transaction to portfolio management
80 90 100 110
Figure 1.20 The conversion premium.
within the US back in 1970 and indeed the North American market is
still the largest.
The seeds of securitization were sewn by the Government National
Mortgage Association (or GNMA). This government sponsored agency
began issuing so-called mortgage pass through certiﬁcates. This is an
asset-backed security representing participation in a pool of mortgages.
The mechanism works through each of the residential mortgage
owners paying their monthly interest and sometimes redemption pay-
ment into a central vehicle. A number of securities will subsequently be
issued into the marketplace and purchased by investors. If we follow
the path of an individual monthly mortgage interest payment it will not
always go to the same security. Indeed sometimes it may represent
a very small component of the coupon for the ﬁrst asset issued and
sometimes it may be a small component of the redemption payment for
the second issue. The point is that the investor has absolutely no inter-
est in the dynamics of a single person’s mortgage actions, however
pooled together into many thousands it will be a relatively stable asset
base which grows in a fairly predictable manner. It is the stable char-
acteristics that the investor is buying into.
Implicit within the last paragraph, is the mechanism of securitiza-
tion. This is virtually synonymous with asset-backed securities. We
have described a pass through arrangement whereby the investor
bears all the risks associated with the collateral. These risks can be
rather unpalatable and consequently the arrangement as it stands
might not be able to successfully issue the proposed securities into the
marketplace. To avoid this possibility the backing may be consolidated.
This is typically known as credit enhancement because the risk is
typically credit in nature. For example in our pool of mortgages some of
the lenders may default. (However the mechanism could also mitigate
pre-payment risk; some property holders may redeem early causing
the investor a headache because instead of receiving a large coupon on
a 10 year bond, for example, unexpectedly receives his capital in an
unfavourable yield environment. The objective of enhancement is to
mitigate this type of scenario, which has nothing to do with credit.)
So far we have discussed asset-backed securities purely from the
investor’s perspective we wish to complement this with the motiv-
ations for the issuer.
If an issuer has made a number of commercial loans, the bulk of
which are ﬁnanced at libor plus a credit related spread. The repack-
aged loans can occasionally be funded at a lower rate because of their
enhanced credit worthiness. This allows the package to be sold off at
a comparable value to that derived at origination. The beneﬁt then is
Fixed income credit 27