Question

A corporation has issued $1,000 par, 8% convertible bonds, callable at par. The bonds are convertible into 20 shares of common stock. Currently, the bond is trading at 102 while the common stock is trading at $52. The corporation calls the bonds at par plus accrued interest of $20 per bond. A customer holds 100 bonds, purchased at par. The customer wishes to liquidate the position at the greatest profit. The BEST recommendation is to (ignoring commissions):

A. tender the bonds at the call price
B. sell the bonds at the current market price
C. sell short the common stock and convert the bonds for delivery to cover the short
D. continue to hold the bonds

Answer 1

Answer:

Correct option is C

sell short the common stock and convert the bonds for delivery to cover the short.

Explanation:

If the bonds are tendered at the call price, the owner receives $1,000 per bond.

If the bonds are sold at the current market price, the owner receives $1,020 per bond. Since each bond is convertible into 20 common shares, the short sale of 20 common shares will yield 20 x $52 = $1,040. The bonds can then be converted to common to cover the short position. Thus, selling short the common stock is the best choice.

Continuing to hold the bonds does not make sense since interest payments will cease.