Who Says Markets Hate Uncertainty?

But now that we’ve established that we really don’t know when, or how much, the stock is going to rise, let’s take the logic a little further. Suppose an alternative to the stock is a five-year convertible bond, trading at 100, with a 5% coupon and a 50% conversion premium. We’re now being honest and admitting we don’t know the future. Let’s go further and evaluate three possible outcomes, two years hence:

• Stock down 20%

• Stock unchanged

• Stock up 80%

If you give each outcome an equal possibility, on average, the stock will be up 20% after the two-year period.¹ But two thirds of the time, you’re either losing a considerable amount of money or making nothing!

Let’s take a look at a likely set of outcomes for the convertible under those scenarios, using initial prices of 50 on the stock and 100 on the bond: