DEFINITION of 'Exchangeable Security'

An exchangeable security is an equity-linked investment instrument that typically involves the issuance of a debt security that can be exchanged at a future date into common stock, or the cash equivalent in some cases. Importantly, it grants its holder the right to trade it for a specified number of shares of common stock of a firm other than the issuer of the exchangeable security.

Exchangeable securities differ from convertible securities in this sense, because they are exchangeable for shares of a different company, while convertible securities are redeemable for shares of the company that issued the convertible security. A certain date or the completion of a specified event at some point in the future that triggers the exchange for common stock is specified with each exchangeable security. They may be structured to be redeemed at the option of the issuer or the holder of the security. An exchangeable security that is automatically exchanged for the underlying common stock, and/or cash, is known as a mandatory exchangeable security.

BREAKING DOWN 'Exchangeable Security'

The holder of the exchangeable security receives a fixed coupon payment from the debt instrument that is typically notably higher than the dividend payment on the underlying common stock for which it can be redeemed. Exchangeable securities use prespecified formulas to determine the number of shares of common stock or cash equivalent that the holder will receive upon exchange. In these formulas, the holder of the exchangeable security is often subject to all of the downside and exposed to most but not all of the upside of holding the subject stock.

For example, assume an exchangeable security is issued for a stock currently trading at $100. The payout formula may be written such that if, at the time of the stated maturity date, the stock is trading at less than $50, the holder will get one share of stock; if it is trading between $100 and $125, the holder will get $100 worth of stock; and if it is trading at higher than $125, the holder will receive 2/3 of a share of stock. Exchangeable securities can be thought of as debt instruments with an embedded option with respect to the underlying common stock.

Usefulness of Exchangeable Securities

Exchangeable securities are sometimes issued by corporations that are involved in a takeover. The acquiring company may wish to purchase the target company, but may need funds to complete the transaction. In this case, the acquiring company can sell an exchangeable security. The exchangeable security would give its owner the right to a specified number of shares in the target company after a specified date. If the acquisition is successful, the exchangeable security can be traded for shares of the target company.

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