Antoine said in another thread: concerning the call features of a convertible bond: when you reach the point when the issuer may call, it is not always, in spite of most model's assumptions, in the interest of the issuer to do so. So in my humble opinion the models are already such a crude representation of human behavior that their very subtle behavior in this case is of little importance. >> Pls expand, what really determines the issuer's behavior?P

To illustrate the problem you might have the look at the Deutsche bank Allianz 3% Convertible: The Implied Vol seems to be in excess of 45%. The listed Options (Exp March 2002) trade at about 33% vol. That's not a proof but it is an indication that something is wrong. If you change the call date on the pricer, you'll find that the implied vol will go to approximately its expected level. Now, there may be another explanation I am not aware of, but my impression is that the market does not believe Allianz will call the bonds for early redemption.One of the explanations (I'm not sure it applies to the previous case) is:The coupon, as an interest payment, is , in terms of taxes, less expensive for the company than it dividend counterpart, so the issuer might want to delay the early redemption. this problem is particularly acute for early redemption calls which have no trigger at all. What most of us guys do is that we put the trigger at the issue price, although we know that the company is not very likely to call at that price.

Is there any money to be made from these 'mispricings'?P

Never did myself but some friends of mine did. The timing of the conversion right, and the status of the shares being converted (are they entitled to the next dividend, i.e are you going to be able to deliver them if you covered with a listed option) are very important.

I think I get more emails about CBs than anything else, whether pricing, hedging or numerical issues.P

I used to buy a lot of convertible bonds and I agree that calls are not always predictable. However, I have never profited from an apparent mistake on the part of the company. Remember that the people making the call decision know a lot more about the stock price and future financial needs of the company than the public.In addition to taxes, the issuer has to consider optionality, transaction costs and investor relations. But my personal inclination is not to put any of that into the pricing model. In principle these create asymmetries between issuer and investor, which means the issuer does not make maximum value out of the call feature from the investor’s perspective, so the bond should be worth more than its simply-computed value. But since, as I say, in my experience the bond is worth less than that level, incorporating these factors may be more realistic but it leads to less accurate prices. If you assume the company is going to do everything possible to hurt you, you will be disappointed less often than someone who thinks they can take advantage of asymmetries.US municipal bonds provide particularly tantalizing examples of call dilemmas. The yield curve is very steep and call premiums are generally quite low. Consider a 4 percent coupon muni with 15 years remaining that can be called immediately (or any time in the future) at $101. The 15-year noncallable muni rate is 5.5 percent and the six month noncallable muni rate is 2.5 percent. Should the issuer call? What should an investor pay for such a bond? This is a typical situation in the market, not a special case.

I partly disagree with you. It's true that issuers tend to have a better forecast of their own stock prices (I'm not absolutely positive, but I think I've seen some paper mentioning that the relative performance of stocks following CB issues is significatively negative). At the same time, if you are not long convert, but short cb and long stock (I think they call it the chinese way), the call situation is not your worst case, but your best case, so I'd prefer to have a better understanding of the issuer's situation. In a way, It's like saying I prefer getting an unbiased implied vol out of the pricer rather than an upwardly biased vol, which is the ideal case only when you're long converts. Now you're gonna tell me most arbitragers are long converts because negative gamma is difficult to manage and because the bond part (especially the credit, which more often then not is not hedged or resold) dampens the theta of the option, so you've got trouble coming from the gamma, and the sure part of your gain smaller than for a usual option.) You're right so 80% of the time it's not that important to ignore the issuer's motives.

I concede that being short a callable bond is a frustrating position. You can do everything right, make money in theory, but lose because the issuer doesn't make an (apparently) optimal call.If that decision were the result of some overlooked financial factor, such as taxes, you have to take your medicine. But it might be simply investor relations. For example, the issuer might be planning to raise additional capital soon and feel that a call will annoy some of its usual large investors. Or the issuer might be asleep at the switch.I don't think there's a good way to model these things. I guess most of them can be considered some sort of cost of exercise to the issuer (such as the cost of hiring people who manage the bonds right), but they are hard to quantify.

What about convertible debentures? You know, non-tradeable, but held by a debtholderas a way of lowering interest costs to the company? Some very interesting valuation issuesfrom the issuers point of view....how do you value the call option when its a non-tradedinstrument? Assume the underlying asset is tradeable of course.

It's the interaction between debenture value, the value of the traded stock and the motivation behind the issuance of such an instrument that's interesting. Do you have a list of different ways of raising capital versus motives behind them? I.e. why go for a bank loan, why sell new shares, why issue convertibles...? What signals do these send out etc.?P

Convertible debs [as they're affectionately known by the debutantes who issue them] are a great way for small caps [or micro caps] to decrease their interest cost of debt [ie the hard cash they must part with each month or quarter] in exchange for possibly juicing the hapless twit that lends them the money when the stock goes through the roof. Of course, it rarely does, which is the beauty of this instrument. When it doesn't, the lenders eventually renegotiate for stiffer terms. The main motivation seems to be co's on an acquisition spree...the lower interest costs matter [and reduce the risk of bankruptcy while buying up other companies].By the time the lenders figure out that heaven will not materialize here on earth, they call a halt to the acquisition spree [ie refuse to lend any more money], crank up the interest rate and convert the convertible debs into straight debt plus some clunky options.And everyone lives miserably ever after.

I just read on the web today [can't remember if its Excite or not] that some geniuses have cottoned on to the fact that perhaps management doth pulleth their chain. Hence, they're suing management for some type of "misrepresentation" -- perhaps this will result in the convertible deb decreasing in popularity.Or, perhaps there is a need for a new type of derivative instrument to hedge away the risk of being sued on a convertible deb issuance.

Actually, I have trouble figuring out who's tricking whom on these deals. It's like the poker game in The Sting, after which Robert Shaw fumes "What was I supposed to do, call him out for cheating better than me?"People who inject cash in shaky business situations need extraordinary provisions to protect themselves; but they often take advantage of that to rig things so they get the entire economic value of the business, to the exclusion of employees and other investors.