Page 61 - PowerPoint Presentation

LOS 36.q: Compare the risk–return characteristics of a
convertible bond with the risk–return characteristics of READING 36: VALUATION AND ANALYSIS: BONDS WITH EMBEDDED OPTIONS
a straight bond and of the underlying common stock.
MODULE 36.8: CONVERTIBLE BONDS
Ownership of the underlying stock or the convertible bond..?

Returns on convertible bonds < return on stock: Why?
Stock’s price up
The convertible bond under performs because of conversion premium (key disadvantage to issuer)

Returns on convertible bonds may > return on stock: Why?
Stock’s price stable Due to the coupon payments received from the bond, assuming no change in interest rates
or credit risk of the issuer.

Returns on convertible bonds > return on stock: Why?
Stock’s price down
The convertible bond’s price has a floor equal to its straight bond value.

Bond Analytics

Implementation BIRT models require specialized software systems. The outputs must meet certain minimum qualifications:

1. Put-call parity
where:
Ensure that the option values obtained conform to basic put-call parity: C and P = value of the embedded
C − P = PV(forward price of the bond on exercise date) − PV(exercise price) call and put option respectively.

2. Option-free bond pricing: The valuation of option-free bonds should be independent of the assumed level of volatility
used to generate the interest rate tree.