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Fair Value of a Convertible Bond The Binomial Model

Fair Value of a Convertible Bond The Binomial Model [Pg.288]

The fair price of a convertible bond is the one that provides no opportunity for arbitrage profit that is, it precludes a trading strategy of running simultaneous but opposite positions in the convertible and the underlying equity in order to realize a profit. Under this approach we consider now an application of the binomial model to value a convertible security. Following the usual conditions of an option pricing model such as Black-Scholes (1973) or Cox-Ross-Rubinstein (1979), we assume no dividend payments, no transaction costs, a risk-free interest rate, and no bid-offer spreads. [Pg.288]

Application of the binomial model requires a binomial tree detailing the price outcomes from the start period, which is shown at FIGURE 13.3. In the case of a convertible bond this will refer to the prices for the underlying asset, which is the ordinary share of the issuing company. [Pg.288]

If we accept that the price of the equity follows such a path, we assume that it follows a multiplicative binomial process. This is a geometric [Pg.288]

The value of a convertible bond is a function of a number of variables. For the purposes of this analysis we set parameters required as follows  [Pg.289]




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