Consider a convertible bond with the information given below; assuming the bond is non-callable and non-puttable.

Maturity = 10 years

Coupon rate = 8%

Conversion ration = 40

Par value = $1,000

Convertible bonds current market price = 920

Current market price per share of the underlying stock = $20

Annual dividend per share = $0.50

Comparable bonds without the conversion option are trading to yield 12%

Suppose, in one month from now, the price of the underlying stock goes up from $20 to $30 per share.

a. What will be the approximate difference in the realized rates of return from investing directly in the underlying stock versus investing in the convertible bond? (2 points)

b. Why did the difference calculated in part a. above occur? (1 point)

Suppose, in one month from now, the price of the underlying stock declines from $20 to $10 per share.

1. What will be the approximate realized rate of return from investing in the underlying stock? (1 point)
2. What will be the approximate realized rate of return from investing in the convertible bond? (3 points)
3. Why did the difference in the realized rates of return calculated in parts a. and b. above occur? (1 point)