Structured products are debt securities that often have unconventional and complex payoff structures. Their payoffs are often linked to a security or index, such as the S&P 500 or the Russell 2000, with asset classes ranging from equity, commodities, currencies to debt. A reverse convertible note is an equity-linked structured product. It is a short-term note that pays a relatively high coupon rate compared to traditional notes. At maturity the returns of the note depends on whether the equity, called 'reference asset', falls below a pre-specified trigger price during the term of the note. If it does, then the note returns the market value of the number of shares of the reference asset which could have been purchased on the note's pricing date with the note's face value. If it does not, then the note returns its face value.
In our previous research we found that equity-linked structured products issued in initial public offerings were overpriced. In this current paper, we show that the reverse convertible is systematically overpriced by brokerage firms.
We value over 530 reverse convertibles issued by multiple investment banks between 2001 and 2010. We find that fair values of these reverse convertibles were between 6.7% and 3.5% lower than their issue price. Moreover, reverse convertibles have significant downside risk with limited upside potential. Yet despite these findings, sales of reverse convertibles continue to grow.
We conclude that investors do not fully understand the expected returns and risks associated with reverse convertibles, and that their complex payoff structures and the lack of secondary markets that would provide a market price for reverse convertibles make it even harder for investors to fully understand such a product.
