Convertible Bond Valuation

Blazes · August 16th, 2011, 12:45 pm

Is there a standard general model/approach for this? If so would someone have a reference to the details of such a model please?

dweeb · August 17th, 2011, 1:24 am

I'll start the ball rolling:Binomial model for just equity risk - see:* Haug's book for converts in binomial trees. * Emanuel Derman et al GS Research Notes Nov-94 - Valuing Converts as Derivatives* Strickland & Clewlow - Implementing Derivative Models - binomial problem with the No. of time stepsAdvanced models for equity risk plus credit and interest rates - see: * Ayache/Forsyth/Vetzal Apr-03 - The Valuation of Convertible Bonds With Credit Risk

Blazes · August 24th, 2011, 1:41 pm

Have been playing with the Derman Binomial model just to make sure I have coded it correctly. I get something counter-intuitive if you set up the model and sample as in the 1994 GS paper. Remove the issuers call and the bond price goes up (makes sense) but now if you remove the holder's put option the value goes up also. Think I can see why it happens. Have others seen this also?

RentMe · August 24th, 2011, 9:13 pm

the bondholder's put always adds value to the convertible, in the fixed income part. Calculate the bond floor with and without the put option, the value is always greater with the put option. In a financial way, if the put is not at the advantage of the bondholder, he can hold the bond until maturity.

Blazes · August 25th, 2011, 7:13 am

RentMe, Thank you. I agree but I am just referring to the particular example and the approach taken. I think it is a function of the different discounting for risky and risk free parts of the price.

RentMe · August 25th, 2011, 10:18 am

Consider only the fixed income part of the CB : coupons, redemption and put.Discount the coupons and the redemption until maturity with the risky yield curveDiscount the coupons and the put strike until put date with the risky yield curveThe bond floor is the max of the two values.