ACCA Advanced Financial Management (AFM) Practice Exam

What type of security is described as a combination of both a bond and a call option?

1. Preferred stock

2. Convertible security

3. Callable bond

4. Equity option

The correct answer is: Convertible security

A convertible security is designed as a hybrid instrument that combines characteristics of both equity and debt. It primarily acts as a bond but includes an embedded call option allowing the holder to convert it into a specific number of shares of the issuing company's stock at predetermined conditions. Convertible securities provide investors with the safety of a fixed income investment along with the potential for capital appreciation through conversion into equity. This unique feature allows investors to benefit from the upside potential of stock price increases while still receiving regular interest payments like those from a bond. In the context of financial management, understanding how convertible securities work is crucial, especially in structuring financing options that attract both risk-averse investors (favoring bond characteristics) and those looking for growth potential (attracted by the equity component). This dual nature is what distinguishes convertible securities from other financial instruments such as preferred stocks, callable bonds, or equity options which do not share the same combination of debt and convertible equity features.