Tuesday, June 18, 2013

Reverse Convertibles and Event Risk

By Tim Dulaney, PhD and Tim Husson, PhD

Reverse convertibles are short-term debt securities issued by banks whose return of principal at maturity is contingent upon the returns of the linked stock.  Although these notes typically pay relatively high coupons, they expose investors to losses on the underlying asset, especially if those losses are beyond the trigger level.  Academic research shows that these coupons are not adequately compensating the investor for the market risk that they are bearing by investing in the notes.  For more information about reverse convertibles, see the collection of posts we have on the subject.

A few years ago, SLCG wrote a white paper (PDF) about a reverse convertible note issued by JP Morgan in May 2010.  What made this particular reverse convertible (PDF) interesting is that JP Morgan issued the note almost simultaneously with the US Appeals Court decision to rehear a case concerning patent litigation between TiVo (TIVO) and Dish Network.  The following figure illustrates the timeline relevant for this note.

Investors in the JP Morgan notes were exposed to the risk that TiVo would experience an adverse litigation event during the term of the notes. Following settlement of the notes, the stock price dropped over 40% and the notes breached the trigger level (dotted red line).  Although the notes paid a 64.25% annualized coupon, investors in the notes experienced an annualized loss of 96%.  This example demonstrates that banks can and do issue structured products around events that could adversely affect their value to investors (events about which the bank likely has much better information).

We wanted to point out another example of such an exposure to highly volatile stocks.  Consider the JP Morgan reverse convertible tied to MetroPCS Communications (PCS) issued on July 27, 2011.  The note was issued just three days before the August 2, 2011 earnings call and quarterly SEC filing from MetroPCS.  MetroPCS's stock price tumbled 37% after " the company missed Wall Street forecasts for its sales, earnings and subscriber growth."  MetroPCS's stock price breached the $12.92 trigger level (dotted red line) and never again returned above the trigger during the term of the notes.

Investors realized an annualized loss of 57% on their investment in the notes.

To see just how significant this drop was, we plot the range of probable levels for PCS based on the risk-free rate, dividend rate, and implied volatility as of the pricing date.  We also plot the range of probable values based on the August 2, 2011 closing price.

As of the pricing date, there was a 70% probability that MetroPCS's stock price would be above the trigger at maturity -- in which case the investor would receive their principal investment (subject to credit risk of course).  After the announcement, there was a 77% chance that MetroPCS's stock price would be below the trigger at maturity -- in which case the notes would convert to MetroPCS stock.

Both the TiVo and MetroPCS reverse convertibles were effectively bets on specific events, bets for which JP Morgan likely had superior ability to determine the odds.  That kind of information asymmetry between banks and investors contributes to the mispricing we commonly observe in the structured product market.  For more examples of structured product valuations and analysis, please see our database of over 17,000 structured products, including 10,000 reverse convertibles.

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