Convertible Security Make-Whole Premium Embedded Option Valuation

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Solution Overview

Problem

Convertible securities do not adequately protect investors from the decrease in value of the option due to changes in the underlying security's volatility, particularly in events like acquisitions or mergers, leading to limited investor willingness to purchase these securities and unfavorable terms for issuers.

Innovation Solution

A convertible security structured with a make-whole premium that is payable upon a fundamental change, determined using a methodology referencing the value of the embedded option, ensuring investors receive compensation for the loss in option value, thereby enhancing protection and attractiveness to investors.

Engineering Contradictions & Design Principles

VSEngineering Contradiction Analysis

1Reliability

If convertible securities provide limited protection through investor put options, then issuer cost is reduced, but investor protection against option value decrease is insufficient

Engineering Contradiction:

Improveinvestor protectionVSAvoidsecurity structure complexity

Core Design Contradiction:

ReliabilityVSDevice complexity

Solution Approach 1:

The patent calculates and establishes a make-whole premium amount in advance at the time of convertible security issuance, based on projected fundamental change scenarios. This preliminary determination ensures investor protection is built into the security structure from the outset, eliminating the need for complex post-event adjustments while providing reliable compensation for option value decreases.

Inventive Principle:

Principle #10Preliminary action

Solution Approach 2:

The patent introduces a new parameter (make-whole premium) that changes based on the difference between the original option value and the option value after fundamental change. This parameter adjustment mechanism automatically compensates investors for volatility-related value decreases without requiring complex structural modifications to the underlying security.

Inventive Principle:

Principle #35Parameter changes

2Reliability

If convertible securities include make-whole premium protection, then investor protection is improved, but issuer cost increases

Engineering Contradiction:

Improveinvestor protectionVSAvoidissuer cost

Core Design Contradiction:

ReliabilityVSLoss of energy

Solution Approach 1:

The patent applies make-whole premium protection selectively - it is calculated and paid only when a fundamental change occurs that decreases option value. In normal circumstances, the premium is not activated, allowing issuers to maintain lower costs while providing enhanced protection when actually needed. This partial application of protection balances investor safety with issuer cost concerns.

Inventive Principle:

Principle #16Partial or excessive action

Solution Approach 2:

The make-whole premium is designed to counteract the adverse effect of fundamental changes on option value. By establishing this compensatory mechanism in advance, the patent prevents investor loss rather than merely providing remediation, thereby reducing the overall cost burden on issuers compared to more extensive protective structures.

Inventive Principle:

Principle #9Preliminary anti-action

3Adaptability or versatility

If convertible securities use traditional investor put protection, then structure simplicity is maintained, but investor willingness to purchase decreases

Engineering Contradiction:

Improveinvestor willingnessVSAvoidsecurity structure complexity

Core Design Contradiction:

Adaptability or versatilityVSDevice complexity

Solution Approach 1:

The make-whole premium is calculated and established at issuance based on anticipated fundamental change scenarios, allowing investors to assess the full protection package before purchasing. This preliminary structuring enhances investor confidence and willingness to purchase without requiring complex ongoing adjustments, as the protection terms are clearly defined from the outset.

Inventive Principle:

Principle #10Preliminary action

4Reliability

If convertible securities account for volatility changes through make-whole premium, then investor protection is enhanced, but calculation complexity increases

Engineering Contradiction:

Improveinvestor protectionVSAvoidcalculation methodology complexity

Core Design Contradiction:

ReliabilityVSDevice complexity

Solution Approach 1:

The patent performs volatility-based option value calculations and establishes the make-whole premium amount in advance at issuance, considering various fundamental change scenarios. This preliminary calculation approach simplifies ongoing administration, as the complex volatility adjustments are predetermined rather than requiring continuous recalculation, thereby enhancing investor protection without proportionally increasing operational complexity.

Inventive Principle:

Principle #10Preliminary action

Data Source

PatentUS7546260B2Convertible security fundamental change make-whole

Publication Date: 2009.06.09 MORGAN STANLEY SERVICES GROUP INC

AI summary

A convertible security structured for issuance to at least one investor by an issuer. The convertible security includes a make-whole premium that is payable to the at least one investor upon conversion following occurrence of a fundamental change involving the issuer of at least one underlying security into which the convertible security is convertible, wherein the make-whole premium is determined by using a methodology established at one of prior to issuance and issuance of the convertible security that references a value of an option embedded in the convertible security.