What is market standard for valuing the option component of convertible asset swap package i.e. effectively american call option to buy CB at par less cancellation value of hedging swap paying CB coupon receiving libor plus spread?There are complex correlated stock, default and IR processes involved. I hear anecdotally that most houses simply value the option approximately at intrinsic value. However, with the recently jump in credit volatility, this would surely be omitting a valuable time value component (i.e. there is a chance that the CB could richen in future due to credit spikes).Any tips or ideas very much appreciated.Jon

i think there are two schools of thoughts. most ASCOT investors (cvt arb hedge funds) have valued this at intrinsic value. some as you say have argue that its also a call on credit. I think if it matters that much then you are in trouble anyway

So isn't there an opportunity if I can buy cheap options priced at intrinsic?Can I either arb with someone who is pricing these including time value? Or just earn profits over time delta hedging the free long gamma position?Thanks

Well... in theory u can, but 1.- u'd need a strong pricing model (at least 3-factor) to accurately compute your deltas, gammas, and cross-gamma2.- u'd need a liquid cds market to hedge (generally cb issuers are entitled to such honors)3.- u'd find out the equity delta dominates the other 2 by farhence most arbs write down that option value to zero, and just manage the vol carry, because the rest is either unmanageable, or too much of a hassle...My view is if it cannot be hedged, then it's worth nothingHaving said that, if u manage a sizeable book on various underlyings, where u're mostly short of those options, then it'd make sense to think of it that way, although u'd still have a lot of delta hedging problems.