Hi,I'm trying to figure out the effect of a dividend increase on the theoritical value of a convertible bond. Why do dividends on stocks negatively effect a convertible bonds theoritical value? Also, more specifically, where in the binomial tree do dividends get modeled (e.g., are they subtracted from the coupon on the bond if is is a nonzero?)? Thanks?

Hi kulmoedee,Dividends are modeled in the forward of the stock price.It has the same negative effect on the price as the dividend in a call option.

In a nutshell, everytime you go long for a call, convertible bond, forward, etc.. on astock you "sell" the dividend..

In the binomial or trinomial tree, you have to substract the dividend from the stock price each time a dividend is due to be paid (to be precise, you have to put the dividend at the date of detachment but with the actual amount at the payment date).The idea is that like the cash equity market, when a dividend is detached (then paid), the stock price falls by the amount of the dividend (we can sometimes hardly see it because the stock always moves and not only when a dividend is paid): if everything's the same, the investor in a stock should have the same value before (stock price only) and after a dividend (lower stock price but investor has received a dividend in cash).The "problem" with options and CBs is that although a dividend is paid to investors in the stock, dividends are not paid to investors in convertible bonds. When you are a CB, you will only receive the dividend if your effectively exercice your right to convert the bond into a stock before the div payment. Like American options, the fact that is a dividend is paid can trigger the exercice of your right to hold a stock. If you keep the CB, you lose the dividend. The higher the dividend the lower the convertible price except when there is a dividend protection clause in the convertible terms (it is the case for most of CBs- e.g. if the dividend is increased by more than 20% or if the dividend is more than 5% of the stock price, you get compensated of your lost by an improvement in the CB terms, generally the parity ratio is higher).