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Decomposing and valuing callable convertible bonds: a new method based on exotic options

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Author Info
Zhou, Qi-Yuan
Wu, Chong-Feng
Feng, Yun
Abstract

In the framework of Black-Scholes-Merton option pricing models, by employing exotic options instead of plain options or warrants, this paper presents an equivalent decomposition method for usual Callable Convertible Bonds (CCB). Furthermore, the analytic valuation formulae for CCB are worked out by using the analytic formulae for those simpler securities decomposed from CCB. Moreover, this method is validated by comparing with Monte Carlo simulation. Besides, the effects of call clauses, coupon clauses and soft call condition clauses are analyzed respectively. These give lots of new insights into the valuation and analysis of CCB and much help to hedge their risks.

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File URL: http://mpra.ub.uni-muenchen.de/7421/
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 7421.

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Date of creation: 16 Feb 2007
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Handle: RePEc:pra:mprapa:7421

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Related research
Keywords: Callable convertible bonds; Equivalent decomposition; Up-and-out calls; American binary calls; Derivative pricing;

Find related papers by JEL classification:
C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

This paper has been announced in the following NEP Reports:

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  1. Boyle, Phelim & Broadie, Mark & Glasserman, Paul, 1997. "Monte Carlo methods for security pricing," Journal of Economic Dynamics and Control, Elsevier, vol. 21(8-9), pages 1267-1321, June. [Downloadable!] (restricted)
  2. Barone-Adesi, Giovanni & Bermudez, Ana & Hatgioannides, John, 2003. "Two-factor convertible bonds valuation using the method of characteristics/finite elements," Journal of Economic Dynamics and Control, Elsevier, vol. 27(10), pages 1801-1831, August. [Downloadable!] (restricted)
  3. McConnell, John J & Schwartz, Eduardo S, 1986. " LYON Taming," Journal of Finance, American Finance Association, vol. 41(3), pages 561-76, July. [Downloadable!] (restricted)
  4. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring. [Downloadable!] (restricted)
  5. Brennan, M J & Schwartz, Eduardo S, 1977. "Convertible Bonds: Valuation and Optimal Strategies for Call and Conversion," Journal of Finance, American Finance Association, vol. 32(5), pages 1699-1715, December. [Downloadable!] (restricted)
  6. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166. [Downloadable!] (restricted)
  7. Brennan, Michael J. & Schwartz, Eduardo S., 1980. "Analyzing Convertible Bonds," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(04), pages 907-929, November. [Downloadable!]
  8. Ingersoll, Jonathan Jr., 1977. "A contingent-claims valuation of convertible securities," Journal of Financial Economics, Elsevier, vol. 4(3), pages 289-321, May. [Downloadable!] (restricted)
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