A Merrill Lynch note structure called a liquid yield option note (LYON) is a zero-coupon instrument that is convertible into the common stock of the issuer. The conversion ratio is fixed for the entire life of the note
If investors wish to convert to the shares of the issuer, they must exchange the LYON for the stock. As a result, the conversion price increases over time. Why?
The formula for conversion ratio is:
conversion ratio = par value of bond / conversion price.
Rearranging we get:
conversion price = (par value of bond)(conversion ratio).
For a zero-coupon bond, the par value of the bond increases over time since interest is not paid in cash but increases the par value of the bond. Thus, from the above formula for the conversion price, we can see that as the par value of the bond increases that the conversion price must increase proportionally since the conversion ratio is constant.
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