A:

Occasionally, a company will need to undergo some financial restructuring to better position itself for long term success. One possible way to achieve this goal is to issue a debt/equity or an equity/debt swap. In the case of an equity/debt swap, all specified shareholders are given the right to exchange their stock for a predetermined amount of debt (i.e. bonds) in the same company. A debt/equity swap works the opposite way: debt is exchanged for a predetermined amount of equity (or stock). The value of the swap is determined usually at current market rates, but management may offer higher exchange values to entice share and debt holders to participate in the swap. After the swap takes place, the preceding asset class is canceled for the newly acquired asset class.

There are many possible reasons why management would wish to restructure a company's finances. One possible reason may be that the company must meet certain contractual obligations, such as a maintaining a debt/equity ratio below a certain number, or a company may issue equity to avoid making coupon and face value payments because they feel they will be unable to do so in the future. The contractual obligations mentioned can be a result of financing requirements imposed by a lending institution, such as a bank, or may be self-imposed by the company, as detailed in the company's prospectus. A company may self-impose certain valuation requirements to entice investors to purchase its stock.

For illustration, assume there is an investor who owns a total of $1,500 in ZXC Corp stock. ZXC has offered all shareholders the option to swap their stock for debt at a rate of 1:1, or dollar for dollar. In this example, the investor would get $1,500 worth of debt if he or she elected to take the swap. If, on the other hand, the company really wanted investors to trade shares for bonds, it can sweeten the deal by offering a swap ratio of 1:1.5. Since investors would receive $2,250 (1.5 * $1,500) worth of debt, they essentially gained $750 for just switching asset classes. However, it is worth mentioning that the investor would lose all respective rights as a shareholder, such as voting rights, if he swapped his equity for debt.

To learn more about evaluating a company's debt and financial strength, read Debt Reckoning or our Fundamental Analysis Tutorial.

RELATED FAQS

  1. How can an investor terminate a derivative contract?

    Read a brief overview about some of the different ways that derivatives traders can terminate their contracts early, including ...
  2. What does the notional principal of a derivative contract refer to?

    Find out more about the notional principal amount, interest rate swap agreements and how the notional principal amount in ...
  3. Who is the counterparty of a derivative?

    Learn about the counterparty to a derivative contract, and how derivative swap agreements traded over the counter have counterparty ...
  4. How are risk weighted assets used to calculate the solvency ratio in regulatory capital ...

    Learn how risk-weighted assets are used to determine solvency ratio requirements under the Basel III accord, and see how ...
RELATED TERMS
  1. ISDA Master Agreement

    A standard agreement used in over-the-counter derivatives transactions.
  2. Circus Swap

    A combination of an interest rate swap and a currency swap in ...
  3. Non-Deliverable Swap - NDS

    A currency swap between major and minor currencies that is restricted ...
  4. LIBOR-in-Arrears Swap

    A swap in which the interest paid on a particular date is determined ...
  5. Catastrophe Swap

    A customizable financial instrument traded in the over-the-counter ...
  6. Look-Alike Contracts

    A financial product, such as a swap or an option, that is traded ...

You May Also Like

Related Articles
  1. No results found.
Trading Center