A convertible security is a bond or preferred stock issue that typically gives its holder the right to exchange it for a stipulated number of shares of common stock of the issuing corporation during a specified period of time. Therefore, convertible bonds and convertible preferred stock represent options to the security holder. If the price of common stock rises sufficiently, holders of these securities will find it profitable to exercise their conversion rights. As for a warrant, such a right will have some positive value in the market, so the market will accept a lower coupon rate on the corporation’s convertible bonds than it would demand for a bond with no conversion privilege. Convertible bonds are especially attractive when management prefers to raise capital by issuing equity rather than debt, but believes that transient influences have led the market to temporarily undervalue its common stock. If this perception is correct, the stock price will rise and, as a result, debt will be converted to equity. A convertible bond issue may offer an advantage over a bond issue with warrants since mangers can predict how much capital the issue will raise. The exercise of a warrant raises further capital for the firm; conversion simply substitutes equity for debt. The conversion of a bond issue for common stock does not raise new capital, but it does implicitly increase cash flow if the conversion occurs prior to the bond’s maturity date, by reducing future coupon payments. A further distinction between warrants and convertible bonds is that warrants are not callable, while the issuer generally can call a convertible bond. The bondholder can be offered the option of converting it within a short time period or surrendering it at a specific cash price. As with all callable bonds, investors demand higher returns for callable, convertible securities. Firms are willing to pay this higher price in exchange for management flexibility. We have seen why a corporation might want to issue a hybrid security rather than straight debt and/or equity. What about the investor? These securities may be particularly attractive when investors have trouble assessing the riskiness of a corporation’s future business activities. If the corporation embarks on a high-risk enterprise, holders of straight bonds will be in the unappealing position of gaining nothing if the enterprise succeeds and facing greatly increased default risk if it fails. Warrants or conversion privileges can restore some balance. By exercising a warrant or converting a bond to stock, the bondholder can share in any success resulting from a risky venture. This reduces the importance of assessing the future business risk of a corporation’s activities.