Exchangeable Security

What Is an Exchangeable Security?

An exchangeable security is an asset that can be traded at a future date for a specified number of shares of common stock or, in some cases, its cash equivalent. The asset is usually a debt security.

Importantly, it grants its holder the right to trade it for shares of the common stock of a company other than the issuer of the exchangeable security. That is the main difference between an exchangeable security and a convertible security, which is redeemable only for shares of the company that issued it.

Exchangeable securities are mainly used by companies engaged in takeovers. The proceeds of the sale of exchangeable securities help finance the acquisition, and the investors are repaid in shares of the newly acquired company.

How an Exchangeable Security Works

The right to trade an exchangeable security is triggered by a specified future event or date. The security may be structured to be redeemed at the option of the issuer or the holder of the security.

An exchangeable security that is automatically swapped for common stock shares or cash is known as a mandatory exchangeable security.

The holder of the exchangeable security receives a fixed coupon payment from the debt instrument. This payment is higher than the dividend payment on the underlying common stock for which it can be redeemed.

Issuers of exchangeable securities use specified 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 potential downside and most of the upside of holding the specified stock.

Exchangeable securities may be issued by a company engaged in a takeover. The securities are swapped for shares of stock in the target company.

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 additional funds to complete the transaction.

In this case, the acquiring company can sell exchangeable securities. 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.

Exchangeable Security Example

For example, assume an exchangeable security is issued for a stock that is currently trading at $100 per share.

The payout formula will specify what the holder will receive at the maturity date, depending on what the price of the stock is on that date. If the stock is trading at less than $50, the holder might get one share of stock. If it is trading between $100 and $125, the holder might get $100 worth of stock. If it is trading at higher than $125, the holder may 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.