What Is an Exchangeable Security?

An exchangeable security is an equity-linked investment instrument that typically involves the issuance of debt security that can be exchanged at a future date with 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 or cash is known as a mandatory exchangeable security.

Key Takeaways

  • An exchangeable security is a financial security that allows its holder to exchange it for the common stock or cash equivalent of another firm.
  • These securities differ from convertible securities, in which the holder of a security must exchange it for shares of the company that issued the convertible security.
  • In a takeover deal, an exchangeable security might be sold by the acquiring firm to investors who would then have the right to trade it for a specific number of shares of the target company at a later date.

How an Exchangeable Security Works

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.

Exchangeable Security Example

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.

Uses 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.