Convertible bonds valuation

FIGURE 9.13 Convertible bond valuation of BNSIM 2%% 2019, on OVCV screen. (Used with permission of Bloomberg L.P. Copyrights 2014. All rights reserved.)... 

The most important Greek for convertible bond valuation is the delta. Delta measures the sensitivity of the option price to changes in the price of the underlying share price as follows (Equation 9.19) ... 

Brennan, M.J., Schwartz, E.S., 1977. Convertible bonds valuation and optimal strategies for call and conversion. J. Financ. 32 (5), 1699-1715. 

In this chapter we present a discussion on convertible bonds, which have become popular hybrid financial instruments. Convertible bonds are financial instmments that give the bondholders the right, without imposing an obligation, to convert the bond into underlying security, usually common stocks, under conditions illustrate in the indenture at the time of issue. The hybrid characteristic defines the traditional valuation approach as the sum of two components the option-free bond and an embedded option (call option). The option element makes the valuation not easy, above all in pricing term sheets with specific contract clauses as the inclusion of soft calls, put options and reset features. The chapter shows practical examples of valuation in which financial advisors and investment banks adopts in different contexts. 

The proposed methodology determines the theoretical value of convertible bonds as the combination of a straight bond and an embedded call optimi. The valuation is performed in three steps ... 

The embedded option component in convertible bonds makes the valuation sensitive from three main parameters share price, volatility and interest rate. These parameters affect the value of a convertible bond for both situations ... 

The Web site associated with this book contains an Excel spreadsheet demonstrating the valuation of convertible bonds. The reader may use the spreadsheet undertake this form of valuation using his or her own parameter inputs. Details of how to access the Web site are contained in the preface. 

What is worthy then of a further investment of cash to purchase this second edition Hopefully the new chapters on asset swap spread relative value, convertible bonds, callable/putable bonds and floating-rate notes will be sufficient justification additionally we have updated the previous chapters on inflation-linked bonds and risky corporate bonds valuation. We have also included Excel spreadsheets that enable the reader to apply the analysis described in the chapters right away to bonds that he or she selects. 

In this chapter, we provide a description of convertible bonds and an overview of issues in their valuation. 

Convertible instruments are usually issued with attached call or put options. Such features can be implemented into the valuation model. If a soft call feature has been implemented, it enables the issuer to force the conversion when the share price overcomes a percentage or trigger level above the conversion price. However, this option cannot be called in the first years hard call . Differently, after the protection period, the issuer can exercise the option. This second time is referred to soft call . Using the same example shown in Section 9.3.1, we assume that the bond may be redeemed in whole but not in part at their principal amount plus accrued interest on the last 2 years, in which the maturity date is at 20 February 2019. On and after this call date , if the share price exceeds 130% of the conversion price the issuer can force the conversion. Figure 9.23 shows the stock price tree in which at years 4 and 5 the stock price is above the threshold. 

The option element in a convertible cannot be stripped out of the bond element, and so is termed an embedded option. The valuation of the bond takes into account this embedded optionality. Note also that unlike a straight equity option, there is no additional payment to make on conversion the holder simply exchanges the bond for the specified number of shares. One could view the price paid for exercising the option as being the loss of the bond element, which is the regular coupon and redemption proceeds on maturity, but this should be viewed as more of an opportunity cost rather than a payment. This bond element is often referred to as the bond floor, which is the straight debt element of the convertible. The bond floor can be viewed as the level at which a vanilla bond issued by the same company would trade, that is, its yield and price. It generally accounts for between 50 percent and 80 percent of the total value. 

---