tailieunhanh - 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. | Pricing of Convertible Bonds with Hard Call Features1 Jolle O. Wever2 and Peter . Smid3 and Ruud H. Koning4 SOM-theme E Financial Markets and Institutions 1This paper is based on the Masters-thesis of the first author. We thank Auke Plantinga for helpful comments. 2Kempen Co Beethovenstraat 300 1077 WZ Amsterdam The Netherlands. 3Department of Economics PO Box 800 9700 AV Groningen The Netherlands. Corresponding author Department of Economics PO Box 800 9700 AV Groningen The Netherlands. Email . Abstract 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. Keywords Convertible bonds hard call binomial trees 1 Introduction The global convertible bond markets is very active at the moment both in terms of issuance and interest from investors. Convertible bonds are popular financing vehicles for a diverse range of companies. Possible motives for