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Pricing And Hedging Convertible Bonds: Delayed Calls And Uncertain Volatility

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    (Fixed Income Quantitative Research, Lehman Brothers International (Europe), 25 Bank Street, London E14 5LE, UK)



    (ICMA Centre, Business School, University of Reading, PO Box 242, Reading RG6 6BA, UK)

Arbitrage-free price bounds for convertible bonds are obtained assuming equity-linked hazard rates, stochastic interest rates and different assumptions about default and recovery behavior. Uncertainty in volatility is modeled using a stochastic volatility process for the common stock that lies within a band but makes few other assumptions about volatility dynamics. A non-linear multi-factor reduced-form equity-linked default model leads to a set of non-linear partial differential complementarity equations that are governed by the volatility path. Empirical results focus on call notice period effects. Increasingly pessimistic values for the issuer's substitution asset obtain as we introduce more uncertainty during the notice period. Uncertain in volatility, in particular, appears to be an important determinant of the call premium that is so often observed in issuer's call policies.

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Article provided by World Scientific Publishing Co. Pte. Ltd. in its journal International Journal of Theoretical and Applied Finance.

Volume (Year): 09 (2006)
Issue (Month): 03 ()
Pages: 415-453

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Handle: RePEc:wsi:ijtafx:v:09:y:2006:i:03:p:415-453
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