Pointless Financial Innovation?

Over at Simon Johnson's Baseline Scenario blog, James Kwak wades into a discussion with a few other journalists about reverse convertibles. He asks:

What the hell is the point of this product?

He concludes, along with Felix Salmon, that it has none and that financial products that don't raise any capital should be outlawed by a possibly soon-to-be-created Financial Product Safety Commission. I'd like to disagree on both accounts, but instead suggest that if such a commission must be created, it should not outlaw any products. At most it should require licensing (to prove the risks are understood) before investors can purchase very complex financial products.

I hate to include such a long block quote, but Kwak does a good job explaining reverse convertibles:

In a reverse convertible, you give $100 to a bank for some period, like a year; it pays you a relatively high rate of interest, say 10%. The $100 is virtually invested (no one actually has to buy the stock) in some underlying stock, like Apple. If at the end of the period the stock is above a threshold, like $80, you get your $100 back; if it is below the threshold, you get the stock instead. (The terms can depend on whether the stock ever went below the threshold and where it is at the end of the period, which makes the deal worse for the investor, but that's the basic idea.)

The simplest thing to compare this to is just buying the stock. Compared to buying the stock, there are three outcomes:

1. The stock ends up below $80: In this case, the reverse convertible is slightly better, because you got the$10 in interest, which is probably more than the dividends you gave up.

2. The stock ends up between $80 and $110: Again, the reverse convertible is better, because you got $110 (your principal plus interest); it's a little better if the stock ends up close to $110, a lot better if the stock ends up at $81.* (see note in Kwak's post).

3. The stock ends up above $110: Here, you do anywhere from a little worse (if the stock ends at $111) to much, much, much worse (if the stock goes over $200).

So what's the point? Well, from an investor perspective, you buy a reverse convertible if you believe the stock price will be above a certain threshold, but not substantially. I'm sure there are also ways a reverse convertible can be used as a hedge. Its usefulness must be clear to someone -- otherwise there would be no market demand for the product, and one never would have been sold.

Moreover, a reverse convertible actually seems like a pretty good alternative to buying the stock. The only scenario in which you're better off having purchased the stock is one in which the stock goes up pretty dramatically. So unless you were buying reverse convertibles of tech stocks in the late 1990s, chances are you have done pretty well with them.

Presented by

Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.

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