Pricing of convertible bonds with hard call features
This paper discusses the development of a valuation model for convertible bonds with hard call features. We define a hard call feature as the possibility for the issuer to redeem a convertible bond before maturity by paying the call price to the bondholder. We use the binomial approach to model convertible bonds with hard call features. By distinguishing between an equity and a debt component we incorporate credit risk of the issuer. The modelling framework takes (discrete) dividends that are paid during the lifetime of the convertible bond, into account. We show that incorporation of the entire zero-coupon yield curve is straightforward. The performance of the binomial model is examined by calculating theoretical values of four convertible bonds. The measure used to compare theoretical values with is the average quote, equal to the average of bid and ask quotes provided by several financial institutions. We conclude that in general long historical volatilities and implied volatilities tend to give the best results. Moreover, we find that our model follows market movements very well. The impact of different dividend and interest rate scenarios is rather small.
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- French, Kenneth R. & Roll, Richard, 1986. "Stock return variances : The arrival of information and the reaction of traders," Journal of Financial Economics, Elsevier, vol. 17(1), pages 5-26, September.
- Craig M. Lewis & Richard J. Rogalski & James K. Seward, 1998. "Understanding The Design Of Convertible Debt," Journal of Applied Corporate Finance, Morgan Stanley, vol. 11(1), pages 45-53.
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