Conversion & Parity Pricing

Overview

Convertible preferred stock allows investors to exchange their security for common stock of the same issuer.

🔑 This chapter covers four subtopics:

1. Benefit to investors
2. Dilutive actions
3. Conversion logistics
4. Anti-dilution covenant

Benefit to investors

• Convertibility benefits the preferred stockholder by adding another potential source of return: capital appreciation.
• Preferred stock is generally treated as a fixed-income investment. It typically pays quarterly dividends, and while its market price can change, most investors don’t buy preferred stock primarily for growth. Preferred prices tend to be less volatile and less growth-oriented than common stock.
• Common stock, by contrast, is usually purchased for its growth potential. Over long periods, stock market returns have averaged around 10% annually, which can translate into meaningful capital gains. Some common stocks also pay cash dividends, so an investor who converts may still receive income.

Dilutive actions

• Issuing a convertible security is a dilutive action for common stockholders because conversion can increase the number of common shares outstanding and reduce each existing shareholder’s percentage ownership.

To see why, assume you own 10 shares of a company with 100 shares outstanding. That gives you 10% ownership. Now assume the company issues convertible preferred shares that would create an additional 100 common shares if converted. If all holders convert, there are now 200 shares outstanding (100 original + 100 new). You still own 10 shares, but now that’s 10/200 = 5% ownership.

Conversion logistics

Conversion ratio

A $100 par, 5% convertible preferred stock with a conversion ratio of 4:1 is trading at $100 per share.

• The conversion ratio tells you how many shares of common stock you receive if you convert one share of preferred stock.
• The issuer sets the conversion ratio at issuance, and it generally stays fixed over the life of the security.
• In this example, a converting preferred stockholder receives 4 shares of common stock for every 1 preferred share.

Worked example — full conversion and sale

An investor purchases 100 shares of $100 par, 5% convertible preferred stock at $100 per share. The preferred shares maintain a conversion ratio of 4:1, while the common stock is trading at $15. A few years later, the common stock rises to $30. The investor converts their shares to common stock and immediately liquidates the position. What is the gain or loss?

Can you figure this one out?

(spoiler)

Answer = $2,000 gain

Step 1: preferred stock purchase Purchase = # of shares x market price Purchase = 100 shares x $100 Purchase = $10,000

Step 2: convert into common shares Conversion = pref. shares x conv. ratio Conversion = 100 shares x 4 Conversion = 400 common shares

Step 3: sell common shares Sale = # of shares x market price Sale = 400 shares x $30 Sale = $12,000

Step 4: compare the original purchase to final sale Return = Sale proceeds - original cost Return = $12,000 - $10,000 Return = $2,000 gain

In this example, the investor profits because the common stock price rises. That’s the key advantage of convertibility: it gives the preferred stockholder a path to participate in common stock appreciation.

Conversion ratio vs. conversion price

🔑 Formulas:

CR = Par / Conversion price

CP = Par / Conversion ratio

Worked example — finding the conversion ratio

An investor purchases 100 shares of a $100 par, 5% preferred stock convertible at $25. What is the conversion ratio?

The formula for the conversion ratio is: CR = Par / Conversion price

Using this formula, can you find the conversion ratio?

(spoiler)

Answer = 4:1

CR = Par / Conversion price CR = $100 / $25 CR = 4

For every share of preferred stock owned, the investor can convert it into 4 shares of common stock. Therefore, the conversion ratio is 4 to 1.

Worked example — finding the conversion price

An investor purchases 100 shares of a $100 par, 5% preferred stock with a 4:1 conversion ratio. What is the conversion price?

The conversion price formula is: CP = Par / Conversion ratio

Using this formula, can you find the conversion price?

(spoiler)

Answer = $25

CP = Par / Conversion ratio CP = $100 / 4 CP = $25

Preferred stock bought at par ($100) can be converted into 4 shares of common stock. That means the investor is effectively paying $25 per share of common stock ($100 / 4), which is the conversion price.

Comparing choices when a call is announced

An investor purchases shares of a $100 par, 7% preferred stock, which is convertible at $25 and callable at 102. A few years later, the preferred stock is trading at $103, while the common stock is trading at $26. If the issuer announces an upcoming call of the preferred stock in 60 days, which of the following options should you recommend to the investor?

A) Allow the shares to be called B) Sell the preferred stock C) Convert to common and sell the shares D) Continue to hold the preferred stock

Can you figure out the best answer?

(spoiler)

Answer: C) Convert to common and sell the shares

Your recommendation should be the choice that provides the most value. Three of the four choices are realistic (A, B, and C). Choice D isn’t realistic because the shares will be called; holding beyond the call date isn’t an available outcome.

Now compare the value of A, B, and C.

A) $102 per share The preferred shares are callable at 102, meaning the issuer will pay 102% of par. For each share, the investor receives $102.

B) $103 per share The call won’t occur for 60 days, so the preferred stock can still trade in the market. At the current market price, the investor could sell for $103.

C) $104 per share If the investor converts, first find the conversion ratio: Par ($100) / conversion price ($25) = 4 Each preferred share converts into 4 common shares. With common stock at $26, the conversion value is $104 (4 x $26).

Since choice C provides the highest value, it’s the best recommendation.

Parity price

Another way to evaluate whether conversion makes sense is to use parity price. There are two parity prices:

1. Common stock parity price
2. Preferred stock parity price

Common stock parity price — worked example

An investor purchases shares of a $50 par, 4% preferred stock at $55. The shares have a conversion price of $10. What is the parity price of the common stock?

Can you figure it out?

(spoiler)

Answer = $11

First, find the conversion ratio using the conversion price ($10): CR = Par / Conversion price CR = $50 / $10 CR = 5:1

Now use the common stock parity price formula: PP (common stock) = Preferred stock market price / Conversion ratio PP (common stock) = $55 / 5 PP (common stock) = $11

This means buying the preferred at $55 and converting is equivalent to paying $11 per share of common stock.

An instant profit exists if the common stock trades above $11.

For example, if the common stock is at $15, an investor could:

• Buy 1 preferred share for $55
• Convert into 5 common shares
• Sell 5 common shares for $75 (5 x $15)

That’s a $20 gain per preferred share.

Arbitrage opportunities

That “instant profit” situation is an arbitrage opportunity. In real markets, these opportunities usually disappear quickly.

Using the same numbers: Preferred stock market price = $55 Conversion ratio = 5:1 Common stock market price = $15

A trader (often using automated systems) could:

• Buy the preferred stock
• Sell the corresponding number of common shares short at the same time

Because conversion and delivery of the common shares can take time, shorting the common stock helps lock in the current market price. When the common shares arrive from conversion, they’re used to close the short position.

Preferred stock parity price — worked example

An investor purchases shares of a $30 par, 4% preferred stock. The shares have a conversion price of $15, while the common stock is trading at $12. What is the parity price of the preferred stock?

Can you figure it out?

(spoiler)

Answer = $24

First, find the conversion ratio using the conversion price ($15): CR = Par / Conversion price CR = $30 / $15 CR = 2:1

Now use the preferred stock parity price formula: PP (preferred stock) = common stock market price x conversion ratio PP (preferred stock) = $12 x 2 PP (preferred stock) = $24

This means the conversion feature alone implies a value of $24 for the preferred stock.

An arbitrage opportunity exists if the preferred stock trades below $24. For example, if the preferred is at $20, an investor could buy it, convert, and sell the common stock for $24 total - earning $4 per preferred share.

Investors use parity prices to help decide whether conversion makes sense. If conversion creates an immediate profit, an arbitrage opportunity exists.

(The chapter includes a video analyzing two different preferred stock parity price questions.)

Anti-dilution covenant

• Virtually all convertible preferred stocks are issued with anti-dilution covenants, which are the issuer’s promise to avoid diluting the value of the conversion feature.

Starting at breakeven (parity)

Assume the following: $100 par convertible preferred stock Preferred stock market price = $100 Conversion ratio = 4:1 Common stock market price = $25

Here, the conversion value equals the preferred’s market price:

• Buy preferred at $100
• Convert into 4 common shares
• Sell common for $100 total ($25 x 4)

If the common stock price rises, conversion becomes more attractive. However, conversion creates new common shares, which dilutes existing common shareholders’ ownership and value.

Why the covenant matters — the stock split problem

Without an anti-dilution covenant, the issuer could take actions that reduce the common stock price and weaken the conversion feature. A stock split is a classic example.

Again, assume: $100 par convertible preferred stock Preferred stock market price = $100 Conversion ratio = 4:1 Common stock market price = $25 2:1 stock split

Pre-split common stock price = $25.00 Pre-split conversion value = $100 ($25.00 x 4) Post-split common stock price = $12.50 Post-split conversion value = $50 ($12.50 x 4)

*Stock splits were initially covered in an earlier chapter.

Anti-dilution covenants require the issuer to adjust the conversion terms when a stock split occurs. The issuer changes the conversion price and conversion ratio so the conversion feature keeps the same economic value.

Worked example — adjusting conversion terms for a 4:1 split

An investor purchases a $100 par, 5% convertible preferred stock with a conversion price of $50. The common stock is currently trading at $40. The issuer performs a 4:1 stock split on the common stock. What is the adjustment to the conversion price and ratio if the preferred stock contains an anti-dilution covenant?

Start by finding the original conversion ratio. CR = Par / Conversion price CR = $100 / $50 CR = 2:1

Initially, each preferred share converts into 2 common shares. With common stock at $40, the conversion value is $80 ($40 x 2).

After a 4:1 stock split, the common stock price adjusts as follows: New common stock price = Current market price / Stock split factor New common stock price = $40 / 4 New common stock price = $10

If the conversion terms didn’t change, the investor would still receive 2 shares worth $10 each, or $20 total. The anti-dilution covenant requires an adjustment so the conversion value remains $80.

To find the new conversion ratio, multiply the original conversion ratio (2) by the stock split factor (4): New conversion ratio = 2 x 4 New conversion ratio = 8

Now each preferred share converts into 8 common shares. At $10 per share, the conversion value is back to $80 (8 x $10).

Do you know what the new conversion price would be?

(spoiler)

Answer = $12.50

You can find this two ways.

Method 1: adjust by the stock split factor Divide the original conversion price ($50) by the stock split factor (4): New conversion price = $50 / 4 New conversion price = $12.50

Method 2: use the conversion price formula with the new ratio CP = Par / Conversion ratio CP = $100 / 8 CP = $12.50

Either method gives the same result.

Key points

Convertible preferred stock

• Convertible into common stock of the same issuer
• Beneficial feature for investors
• Sold with lower dividend rates (vs. non-convertible)
• Higher prices & lower yields

Conversion ratio

• CR = Par / conversion price

Conversion price

• CP = Par / conversion ratio

Common stock parity price

• Price paid per common share based on convertible security market price
• PPoCS = Preferred stock market price / Conversion ratio

Preferred stock parity price

• Value of preferred stock based only on the conversion feature
• PPoPS = common stock market price x conversion ratio

Bond parity price

• Value of bond based on its conversion feature
• BPP = stock price x conv. ratio

Anti-dilution covenant

• Prevents issuer from performing dilution actions without adjusting the conversion feature
• Involved when stock splits occur
• Conversion ratio goes up
• Conversion price goes down

Sources

Primary/official references for the material in this chapter. Every link was fetched and returned HTTP 200 on 2026-08-15.