Pricing Convertible Bond
Pricing Convertible Bond
Pricing Convertible Bond
Tim Xiao1
ABSTRACT
This paper presents a new model for valuing hybrid defaultable financial instruments, such as,
convertible bonds. In contrast to previous studies, the model relies on the probability distribution of a
default jump rather than the default jump itself, as the default jump is usually inaccessible. As such, the
model can back out the market prices of convertible bonds. A prevailing belief in the market is that
convertible arbitrage is mainly due to convertible underpricing. Empirically, however, we do not find
evidence supporting the underpricing hypothesis. Instead, we find that convertibles have relatively large
positive gammas. As a typical convertible arbitrage strategy employs delta-neutral hedging, a large
positive gamma can make the portfolio highly profitable, especially for a large movement in the
Key Words: hybrid financial instrument, convertible bond, convertible underpricing, convertible
1
The views expressed here are of the author alone and not necessarily of his host institution.
Address correspondence to Tim Xiao, Risk Quant, Capital Markets, CIBC, 161 Bay Street, 10th Floor, Toronto, ON
M5J 2S8, Canada; email: Tim.Xiao@CIBC.com or tim_yxiao@yahoo.com
1. Introduction
A company can raise capital in financial markets either by issuing equities, bonds, or hybrids
(such as convertible bonds). From an investor’s perspective, convertible bonds with embedded optionality
offer certain benefits of both equities and bonds – like the former, they have the potential for capital
appreciation and like the latter, they offer interest income and safety of principal. The convertible bond
There is a rich literature on the subject of convertible bonds. Arguably, the first widely adopted
model among practitioners is the one presented by Goldman Sachs (1994) and then formalized by
Tsiveriotis and Fernandes (1998). The Goldman Sachs’ solution is a simple one factor model with an
equity binomial tree to value convertible bonds. The model considers the probability of conversion at
every node. If the convertible is certain to remain a bond, it is then discounted by a risky discount rate that
reflects the credit risk of the issuer. If the convertible is certain to be converted, it is then discounted by
Tsiveriotis and Fernandes (1998) argue that in practice one is usually uncertain as to whether the
bond will be converted, and thus propose dividing convertible bonds into two components: a bond part
that is subject to credit risk and an equity part that is free of credit risk. A simple description of this model
and an easy numerical example in the context of a binomial tree can be found in Hull (2003).
Grimwood and Hodges (2002) indicate that the Goldman Sachs model is incoherent because it
assumes that bonds are susceptible to credit risk but equities are not. Ayache et al (2003) conclude that
the Tsiveriotis-Fernandes model is inherently unsatisfactory due to its unrealistic assumption of stock
prices being unaffected by bankruptcy. To correct this weakness, Davis and Lischka (1999), Andersen
and Buffum (2004), Bloomberg (2009), and Carr and Linetsky (2006) etc., propose a jump-diffusion
model to explore defaultable stock price dynamics. They all believe that under a risk-neutral measure the
expected rate of return on a defaultable stock must be equal to the risk-free interest rate. The jump-
1
The jump-diffusion model was first introduced by Merton (1976) in the market risk context for
modeling asset price behavior that incorporates small day-to-day diffusive movements together with
larger randomly occurring jumps. Over the last decade, people attempt to propagate the model from the
market risk domain to the credit risk arena. At the heart of the jump-diffusion models lies the assumption
that the total expected rate of return to the stockholders is equal to the risk-free interest rate under a risk-
neutral measure.
Although we agree that under a risk-neutral measure the market price of risk and risk preferences
are irrelevant to asset pricing (Hull, 2003) and thereby the expectation of a risk-free2 asset grows at the
risk-free interest rate, we are not convinced that the expected rate of return on a defaultable asset must be
also equal to the risk-free rate. We argue that unlike market risk, credit risk actually has a significant
impact on asset prices. This is why regulators, such as International Accounting Standards Board (IASB),
Basel Committee on Banking Supervision (BCBS), etc. require financial institutions to report a credit
value adjustment (CVA) in addition to the risk-free mark-to-market (MTM) value to reflect credit risk
(Xiao, 2013). By definition, a CVA is the difference between the risk-free value and the risky value of an
asset/portfolio subject to credit risk. CVA implies that the risk-free value should not be equal to the risky
value in the presence of default risk. As a matter of fact, we will prove that the expected return of a
defaultable asset under a risk-neutral measure actually grows at a risky rate rather than the risk-free rate.
Because of their hybrid nature, convertible bonds attract different type of investors. Especially,
convertible arbitrage hedge funds play a dominant role in primary issues of convertible debt. In fact, it is
believed that hedge funds purchase 70% to 80% of the convertible debt offered in primary markets. A
prevailing belief in the market is that convertible arbitrage is mainly due to convertible underpricing (i.e.,
the model prices are on average higher than the observed trading prices) (see Ammann et al (2003),
Calamos (2011), Choi et al (2009), Loncarski et al (2009), etc.). However, Agarwal et al (2007) and Batta
et al (2007) argue that the excess returns from convertible arbitrage strategies are not mainly due to
2
Here, risk-free means free of credit risk, but not necessarily of market risk
2
underpricing, but rather partly due to illiquid. Calamos (2011) believes that arbitrageurs in general take
advantage of volatility. A higher volatility in the underlying equity translates into a higher value of the
equity option and a lower conversion premium. Multiple views reveal the complexity of convertible
arbitrage, involving taking positions in the convertible bond and the underlying asset that hedges certain
risks but leaves managers exposed to other risks for which they reap a reward.
This article makes a theoretical and empirical contribution to the study of convertible bonds. In
contrast to the above mentioned literature, we present a model that is based on the probability distribution
(or intensity) of a default jump (or a default time) rather than the default jump itself, as the default jump is
usually inaccessible (see Duffie and Huang (1996), Jarrow and Protter (2004), etc).
We model both equities and bonds as defaultable in a consistent way. When a firm goes bankrupt,
the investors who take the least risk are paid first. Secured creditors have the best chances of seeing the
value of their initial investments come back to them. Bondholders have a greater potential for recovering
some their losses than stockholders who are last in line to be repaid and usually receive little, if anything.
The default proceedings provide a justification for our modeling assumptions: Different classes of
securities issued by the same company have the same default probability but different recovery rates.
Given this model, we are able to back out the market prices.
Valuation under our risky model can be solved by common numerical methods, such as, Monte
Carlo simulation, tree/lattice approaches, or partial differential equation (PDE) solutions. The PDE
algorithm is elaborated in this paper, but of course the methodology can be easily extended to tree/lattice
or Monte Carlo.
Using the model proposed, we conduct an empirical study of convertible bonds. We obtain a data
set from FinPricing (2017). The data set contains 164 convertible bonds and 2 years of daily market prices
as well as associated interest rate curves, credit curves, stock prices, implied Black-Scholes volatilities
The most important parameter to be determined is the volatility input for valuation. A common
approach in the market is to use the at-the-money (ATM) implied Black-Scholes volatility to price
3
convertible bonds. However, most liquid stock options have relatively short maturates (rarely more than 8
years). As a result, some authors, such as Ammann et al (2003), Loncarski et al (2009), Zabolotnyuk et al
(2010), have to make do with historical volatilities. Therefore, we segment the sample into two sets
according to maturity: a short-maturity class (0 ~ 8 years) and a long-maturity class (> 8 years). For the
short-maturity class, we use the ATM implied Black-Scholes volatility for valuation, whereas for the
long-maturity class, we calculate the historical volatility as the annualized standard deviation of the daily
log returns of the last 2 years and then price the convertible bond based on this real-world volatility.
The empirical results show that the model prices fluctuate randomly around the market prices,
indicating the model is quite accurate. Our empirical evidence does not support a systematic underpricing
hypothesis. A similar conclusion is reached by Ammann et al (2008) who use a Monte-Carlo simulation
approach. Moreover, market participants almost always calibrate their models to the observed market
prices using implied convertible volatilities. Therefore, underpricing may not be the main driver of
It is useful to examine the basics of the convertible arbitrage strategy. A typical convertible bond
arbitrage employs delta-neutral hedging, in which an arbitrageur buys a convertible bond and sells the
underlying equity at the current delta (see Choi et al (2009), Loncarski et al (2009), etc.). With delta
neutral positions, the sign of Gamma is important. If Gamma is negative, the portfolio profits so long as
the underlying equity remains stable. If Gamma is positive, the portfolio will profit from large movements
We study the sensitivities of convertible bonds and find that convertible bonds have relatively
large positive gammas, implying that convertible arbitrage can make a profit on a large upside or
downside movement in the underlying stock price. Since convertible bonds are issued mainly by start-up
or small companies (while more established firms rely on other means of financing), the chance of a large
movement in either direction is very likely. Even for very small movements in the underlying stock price,
profits can still be generated from the yield of the convertible bond and the interest rebate for the short
position.
4
The rest of this paper is organized as follows: The model is presented in Section 2. Section 3
elaborates the PDE approach; Section 4 discusses the empirical results. The conclusions are provided in
2 Model
Convertible bonds can be thought of as normal corporate bonds with embedded options, which
enable the holder to exchange the bond asset for the issuer’s stock. Despite their popularity and ubiquity,
convertible bonds still pose difficult modeling challenges, given their hybrid nature of containing both
debt and equity features. Further complications arise due to the frequent presence of complex contractual
clauses, such as, put, hard call, soft call, and other path-dependent trigger provisions. Contracts of such
complexity can only be solved by numerical methods, such as, Monte Carlo simulation, tree/lattice
From a practitioner’s perspective, Monte Carlo is a “last resort” and “least preferred” method,
whereas lattice or PDE approaches suffer from the curse of dimensionality: The number of evaluations
and computational cost increase exponentially with the dimension of the problem, making it impractical
Three sources of randomness exist in a convertible bond: the stock price, the interest rate, and the
credit spread. As practitioners tend to eschew models with more than two factors, it is a legitimate
question: How can we reduce the number of factors or which factors are most important? Grimwood and
Hodges (2002) conduct a sensitivity study and find that accurately modeling the equity process appears
crucial. This is why all convertible bond models in the market capture, at a minimum, the dynamics of the
underlying equity price. Since convertible bonds are issued mainly by start-up or small companies (while
more established firms rely on other means of financing), credit risk plays an important role in the
valuation. Grimwood and Hodges (2002) further note that the interest rate process is of second order
importance. Similarly, Brennan and Schwartz (1980) conclude that the effect of a stochastic interest rate
5
on convertible bond prices is so small that it can be neglected. Furthermore, Ammann et al (2008) notice
that the overall pricing benefit of incorporating stochastic interest rates would be very limited and would
not justify the additional computational costs. For these reasons, most practical convertible models in the
where denotes a sample space, F denotes a -algebra, P denotes a probability measure, and
where S (t ) denotes the stock price, r (t ) denotes the risk-free interest rate, denotes the volatility,
Equation (2) tells us that in a risk-neutral world, the expected return on a risk-free stock is the
risk-free interest rate r (t ) , i.e., the discounted stock price under the risk neutral measure is a martingale
process.
Next, we turn to a defaultable stock. The defaultable stock process proposed by Davis and
Lischka (1999), Andersen and Buffum (2004), and Bloomberg (2009), etc., is given by
where U (t ) is an independent Poisson process with dU (t ) 1 with probability h(t )dt and 0 otherwise,
h(t ) is the hazard rate or the default intensity, S (t ) is the stock price immediately before any jump at
6
EdS (t ) F t r (t ) h(t )S (t )dt S (t )h(t )dt r (t )S (t )dt (4)
It is shown in equation (4) that the expected return of a defaultable stock under a jump-diffusion
model also grows at the risk-free interest rate. Equation (3) is a simpler version of the Merton’s Jump-
The jump-diffusion model was first proposed in the context of market risk, which naturally
exhibits high skewness and leptokurtosis levels and captures the so-called implied volatility smile or skew
effects. Ederington and Lee (1993) find that the markets tend to have overreaction and underreaction to
the outside news. The jump part of the model can be interpreted as the market response to outside news. If
there is not any outside news, the asset price changes according to a geometric Brownian motion. Since
the market price of risk and risk preferences are irrelevant to asset pricing within the market risk context,
the expected rate of return to the stockholders is equal to the risk-free rate under a risk-neutral measure.
from the market risk domain to the credit risk domain, as credit risk actually impacts the valuation of
assets. This is why financial institutions are required by regulators to report CVA. In fact, we will show in
the following derivation that the expected return of a defaultable asset under a risk-neutral measure is
actually equal to a risky rate instead of the risk-free rate. This conclusion is very important for risky
valuation.
The world of credit modeling is divided into two main approaches: structural models and
reduced-form (or intensity) models. The structural models regard default as an endogenous event,
focusing on the capital structure of a firm. The reduced-form models do not explain the event of default
endogenously, but instead characterize it exogenously as a jump process. In general, structural models are
based on the information set available to the firm's management, such as the firm’s assets and liabilities;
while reduced-form models are based on the information set available to the market, such as the firm’s
bond prices or credit default swap (CDS) premia. Many practitioners in the credit trading arena have
tended to gravitate toward the reduced-from models given their mathematical tractability. The reduced-
7
form models can be made consistent with the risk-neutral probabilities of default backed out from
In the reduced-form models, the stopping (or default) time of a firm is modeled as a Cox
arrival process (also known as a doubly stochastic Poisson process) whose first jump occurs at default and
is defined as,
t
inf t : h(s, s )ds
0
(5)
where h(t ) or h(t , t ) denotes the stochastic hazard rate or arrival intensity dependent on an exogenous
It is well-known that the survival probability from time t to s in this framework is defined by
The default probability for the period (t, s) in this framework is given by
We consider a defaultable asset that pays nothing between dates t and T. Let V (t ) and V (T )
denote its values at t and T, respectively. Risky valuation can be generally classified into two categories:
the default time approach (DTA) and the default probability (intensity) approach (DPA).
The DTA involves the default time explicitly. If there has been no default before time T (i.e.,
payoff is made at the default time as a fraction of the market value3 given by V ( ) where is the
default recovery rate and V ( ) is the market value at default. Under a risk-neutral measure, the value of
this defaultable asset is the discounted expectation of all the payoffs and is given by
3
Here we use the recovery of market value (RMV) assumption.
8
where Y is an indicator function that is equal to one if Y is true and zero otherwise, and D(t , ) denotes
D(t , ) exp r (u )du (9)
t
Although the DTA is very intuitive, it has the disadvantage that it explicitly involves the default
time/jump. We are very unlikely to have complete information about a firm’s default point, which is often
replacement cost of the transaction, where the replacement is also defaultable4. Therefore V ( ) should be
determined via another risky valuation and so forth. Usually, valuation under the DTA is performed via
The DPA relies on the probability distribution of the default time rather than the default time
itself. We divide the time period (t, T) into n very small time intervals ( t ) and assume that a default may
occur only at the end of each very small period. In our derivation, we use the approximation exp y 1 y
for very small y. The survival and default probabilities for the period ( t , t t ) are given by
The binomial default rule considers only two possible states: default or survival. For the one-
period ( t , t t ) economy, at time t t the asset either defaults with the default probability
q(t , t t ) or survives with the survival probability p(t , t t ) . The survival payoff is equal to the
market value V (t t ) and the default payoff is a fraction of the market value: (t t )V (t t ) . Under
a risk-neutral measure, the value of the asset at t is the expectation of all the payoffs discounted at the
4
Many people in the market use the risk-free value as the market-value-at-default, which is inappropriate
as any contract in the OTC market is risky when taking counterparty risk into account.
9
V (t ) Eexp r (t )t pˆ (t ) (t )qˆ (t )V (t t ) F t Eexp y(t )t V (t t ) F t (12)
where y(t ) r (t ) h(t )1 (t ) r (t ) c(t ) denotes the risky rate and c(t ) h(t )1 (t ) is called the
Similarly, we have
Note that exp y(t )t is Ft t -measurable. By definition, an Ft t -measurable random
variable is a random variable whose value is known at time t t . Based on the taking out what is
V (t ) Eexp y (t )t V (t t ) F t
Eexp y (t )t E exp y (t t )t V (t 2t ) F t t F t (14)
E exp
1
i 0
y (t it )t ) V (t 2t ) F t
By recursively deriving from t forward over T and taking the limit as t approaches zero, the
Using the DPA, we obtain a closed-form solution for pricing an asset subject to credit risk.
Another good example of the DPA is the CDS model proposed by J.P. Morgan (1999).
The derivation of equation (15) takes into account all credit characteristics: possibility of a jump
to default and recovery rate. It tells us that a defaultable asset under the risk-neutral measure grows at a
risky rate. The risky rate is equal to a risk-free interest rate plus a credit spread. If the asset is a bond, the
equation is the same as Equation (10) in Duffie and Singleton (1999), which is the market model for
pricing risky bonds. The market bond model says that the value of a risky bond is obtained by discounting
the promised payoff using the risk-free interest rate plus the credit spread5.
5
There is a liquidity component in the bond spread. This paper, however, focuses on credit risk only.
10
Under a risk-neutral measure the market price of risk and risk preferences are irrelevant to asset
pricing (Hull, 2003) and thereby the expectation of a risk-free asset grows at the risk-free interest rate.
However, credit risk actually has a significant impact on asset prices. This is the reason that regulators,
such as IASB and BCBS, require financial institutions to report a CVA in addition to the risk-free MTM
In asset pricing theory, the fundamental no-arbitrage theorems do not require expected returns to
be equal to the risk free rate, but only that prices are martingales after discounting under the numeraire.
For risk-free valuation, people commonly use a risk-free bond as the numeraire, whereas for risky
valuation, they should choose an associated risky numeraire to reflect credit risk. The expected return is
If a company files bankruptcy, both bonds and stocks go into a default status. In other words, the
default probabilities for both of them are the same (i.e., equal to the firm’s probability of default). But the
recovery rates are different because the stockholders are the lowest priority in the list of the stakeholders
in the company, whereas the bondholders have a higher priority to receive a higher percentage of invested
funds. The default proceedings provide a justification for our modeling assumptions: Different classes of
securities issued by the same company have the same default probability but different recovery rates.
According to equation (15), we propose a risky model that embeds the probability of the default
jump rather than the default jump itself into the price dynamics of an asset. The stochastic differential
where s is the recovery rate of the stock and y(t ) r (t ) h(t )1 s (t ) is the risky rate.
For most practical problems, zero recovery at default (or jump to zero) is unrealistic. For example,
the stock of Lehman Brothers fell 94.3% on September 15, 2008 after the company filed for Chapter 11
bankruptcy. Similarly, the shares of General Motors (GM) plunged 32% on June 1, 2009 after the firm
11
initiated Chapter 11 bankruptcy. A good framework should flexibly allow people to incorporate different
Equation (16) is the direct derivation of equation (15). The formula allows different assumptions
concerning recovery on default. In particular, s 0 represents the situation where the stock price jumps
Equation (17) says that the expected return of a stock subject to credit risk is equal to a risky rate
rather than the risk-free rate. The risky rate reflects the compensation investors receive for bearing credit
risk.
3. PDE Algorithm
The numerical solution of our risky model can be obtained by either PDE methods, tree
approaches, or Monte Carlo simulation. In this paper, we introduce the PDE procedure, but of course the
The valuation of a convertible bond normally has a backward nature since there is no way of
knowing whether the convertible should be converted without knowledge of the future value. Only on the
maturity date, the value of the convertible and the decision strategy are clear. If the convertible is certain
to be converted, it behaves like a stock. If the convertible is not converted at an intermediate node, we are
usually uncertain whether the continuation value should be treated as a bond or a stock, because in
backward induction the current value takes into account the results of all future decisions and some future
values may be dominated by the stock or by the bond or by both. Therefore, we arrange the valuation so
12
that the value of the convertible at each node is divided into two components: a component of bond and a
component of stock, i.e. L(S , t ) G(S , t ) B(S , t ) where G( S , t ) denotes the equity part of the
convertible bond and B(S , t ) denotes the bond part of the convertible.
Suppose that G(S , t ) is some function of S and t. Applying Ito Lemma, we have
G G 1 2 2 2 G G
dG S S dt S
2
dW (19)
S t 2 S S
Since the Wiener process underlying S and G are the same, we can construct the following
G
X GS (20)
S
Therefore, we have
G G 1 2 2 2 G
dX dG dS S dt (21)
S t 2 S 2
In contrast to all previous studies, we believe that the defaultable equity should grow at the risky
rate of the equity including dividends, whereas the equity part of the convertible bond should earn the
G
r h(1 s )Gdt r q h(1 s ) G Sdt dX G 1 2 S 2
2
dt (22)
S t 2 S 2
So that the PDE of the equity component is given by
G 1 2 2 2 G G
S r q h(1 s ) S r h(1 s ) G 0 (23)
t 2 S 2
S
Similarly applying Ito Lemma to the bond part of the convertible B(S , t ) , we obtain
B B 1 2 2 2 B B
dB S S dt S
2
dW (24)
S t 2 S S
Let us construct a portfolio so that we can eliminate the Wiener process as follows
B
Y BS (25)
S
Thus, we have
13
B B 1 2 2 2 B
dY dB dS S dt (26)
S t 2 S 2
The defaultable equity should grow at the risky rate of the equity including dividends, while the
bond part of the convertible bond grows at the risky rate of the bond. Consequently, we have
B
r h(1 b )Bdt r q h(1 s ) B Sdt dY B 1 2 S 2
2
dt (27)
S t 2 S 2
the terms and conditions of each individual convertible and need to be solved simultaneously. Convertible
bonds often incorporate various additional features, such as call and put provisions.
min Pc , max Pp , N C ,
BT
if ST min Pc , max Pp , N C (30)
0, otherwise
where N denotes the bond principal, C denotes the coupon, Pc denotes the call price, Pp denotes the put
price and denotes the conversion ratio. The final conditions tell us that the convertible bond at the
maturity is either a debt or an equity.
The upside constraints at time t [0, T ] are
Gt S t , Bt 0
if S t min Pc , max P , L~
p t
~
Gt 0, Bt Pp else if Lt Pp
(31)
~
Gt 0, Bt Pc else if Lt Pc
Gt G~ ~
t , Bt Bt else
~ ~ ~ ~
where Lt Bt Gt is the continuation value of the convertible bond, Bt is the continuation value of the
~
bond component and Gt is the continuation value of the equity component. Equation (31) says that the
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convertible is either in the continuation region or one of the three constraints (called, put or converted).
One can use finite difference methods to solve the PDEs (23) and (28) for the price of a convertible bond.
4. Empirical results
This section presents the empirical results. We use two years of daily data from September 10,
2010 to September 10, 2012, i.e., a total of 522 observation days. This proprietary data are obtained from
an investment bank. They consist of convertible bond contracts, market observed convertible prices,
interest rate curves, credit curves, stock prices, implied Black-Scholes volatilities and recovery rates.
We only consider the convertibles outstanding during the period and with sufficient pricing
information. As a result, we obtain a final sample of 164 convertible bonds and a total of 164 × 522 =
85,608 observations. None of the convertibles in this sample actually defaulted during the time window.
As of September 10, 2012, the sample represents a family of convertible bonds with maturities
ranging from 2 months to 36.6 years, and has an average remaining maturity of 4.35 years. The histogram
of contracts on September 10, 2012 for various maturity classes is given in Figure 1.
Convertible bond prices observed in the market will be compared with theoretical prices under
different volatility assumptions. The sample is segmented into two sets according to maturities: a short-
maturity class (0 ~ 8 years) and a long-maturity class (> 8 years). We first select a convertible bond from
each group: a 7-year (or 5-year outstanding) contract and a 20-year (or 17-year outstanding) contract
shown in Table 1.
This histogram splits the total number of convertible bonds of the sample into different classes according
to the maturity of each convertible bond. The x-axis represents maturities in years and the y-axis
represents the number of convertibles in each class. The n maturity class covers contracts with maturities
15
Table 1. Convertible bond examples
We hide the issuer names according to the security policy of the investment bank, but everything else is
authentic. In the market, either a conversion price or a conversion ratio is given for a convertible bond,
where conversion ratio = (face value of the convertible bond) / (conversion price).
16
Let valuation date be September 10, 2012. An interest rate curve is the term structure of interest
rates, derived from observed market instruments that represent the most liquid and dominant interest rate
products for certain time horizons. Normally the curve is divided into three parts. The short end of the
term structure is determined using the London Interbank Offered Rates (LIBOR). The middle part of the
curve is constructed using Eurodollar futures that require convexity adjustments. The far end is derived
using mid swap rates. The LIBOR-future-swap curve is presented in Table 2. We bootstrap the curve and
This table displays the closing prices as of September 10, 2012. These instruments are used to construct
17
15 year swap rate 2.2783%
20 year swap rate 2.4782%
25 year swap rate 2.5790%
30 year swap rate 2.6422%
The equity information and recovery rates are provided in Table 3. To determine hazard rates, we
need to know the observed market prices of corporate bonds or CDS premia, as the market standard
practice is to fit the implied risk-neutral default intensities to these credit sensitive instruments. The
corporate bond prices are unfortunately not available for companies X and Y, but their CDS premia are
observable as shown in Table 4. Usually the CDS market leads the bond market, in particular during crisis
situation. Liquidity in the bond market is typically drying up during a financial crisis. Demand for
insurance against default risk, on the other hand, increases if the issuer is experiencing financial stress.
Consequently, prices and spreads derived from the CDS market tend to be more reliable. Said differently,
CDSs on reference entities are often more actively traded than bonds issued by the same entities.
Unlike other studies that use bond spreads for pricing (see Tsiveriotis and Fernandes (1998),
Ammann et al (2003), Zabolotnyuk et al (2010), etc.), we perform risky valuation based on credit
information extracted from CDS spreads. Given the recovery rates and the CDS premia, we can compute
the hazard rates via a standard calibration process (J.P. Morgan, 2001).
This table displays the closing stock prices and dividend yields on September 10, 2012, as well as the
recovery rates
Company X Company Y
Stock price 34.63 23.38
Dividend yield 2.552% 3.95%
Bond recovery rate 40% 36.14%
Equity recovery rate 2% 1%
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Table 4. CDS premia
This table displays the closing CDS premia as of September 10, 2012.
The most important input parameter to be determined is the volatility for valuation. A common
approach in the market is to use ATM implied Black-Scholes volatilities to price convertible bonds. For
the 5-year outstanding convertible bond (case 1 in Table 1), we find the ATM implied Black-Scholes
volatility is 31.87%, and then price the convertible bond accordingly. The results are shown in Table 5.
For the 17-year outstanding convertible bond (case 2 in Table 1), however, most liquid stock
options have relatively short maturates (rarely more than 8 years). Therefore, some authors, such as
Ammann et al (2003), Loncarski et al (2009), Zabolotnyuk et al (2010), have to make do with historical
volatilities. Similarly, we calculate the historical volatility as the annualized standard deviation of the
daily log returns of the last 2 years (from September 10, 2010 to September 10, 2012), and then value the
convertible bond based on this real-world volatility. The result shown in Table 5 reports an underpricing
of 1.07%. The test results demonstrate that the model prices are very close to the market prices, indicating
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Table 5. Model prices vs. market prices
This table shows the differences between the model prices and the market prices of the convertible bonds
under different volatility assumptions, where Difference = (Model price) / (Market observed price) – 1.
We repeat this exercise for all contracts on all observation dates. For any short-maturity
convertible bond, we use the ATM implied Black-Scholes volatility for pricing, whereas for any long-
maturity convertible bond, we perform valuation via the historical volatility. The results are presented in
Tables 6.
Underpricing
Maturity Observations
Mean (%) Std (%) Max (%) Min (%)
≤ 8 years 82998 -0.13 1.37 0.79 -1.08
> 8 years 2610 1.67 2.03 2.24 0.58
Next, our sample is partitioned into subsamples according to the moneyness of convertibles. The
moneyness is measured by the ratio of the conversion value to the equivalent straight bond value or the
investment value. The underpricing of each daily observation with respect to the degree of moneyness is
shown in Table 7, where moneyness between 0 and 0.9 corresponds to out-of-the-money; moneyness
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between 0.9 and 1.1 represents around-the-money; and moneyness higher than 1.1 is related to in-the-
money.
The moneyness is measured by dividing the conversion value through the associated straight bond value.
An observation corresponds to a snapshot of the market used to price a convertible bond at a certain
valuation date.
Underpricing
Moneyness Observations
Mean (%) Std (%)
< 0.5 5794 0.72 2.23
0.5 – 0.7 10595 -0.87 2.37
0.7 – 0.9 19850 0.51 1.64
0.9 – 1.1 14737 0.45 1.12
1.1 – 1.3 14379 -0.55 1.89
1.3 – 1.5 11631 -0.42 2.04
> 1.5 8622 -0.62 1.72
From Tables 7, it can be seen that the model prices fluctuate randomly around the market prices
(sometimes overpriced and sometimes underpriced), indicating the model is quite accurate. Empirically,
we do not find support for presence of a systematic underpricing as indicated in previous studies (see
Carayannopoulos and Kalimipalli (2003), Ammann et al (2003), etc.). If there is no underpricing, how has
the arbitrage strategy been successful in the past? Maybe convertible arbitrage is not solely based on
underpricing.
In a typical convertible bond arbitrage strategy, the arbitrageur entails purchasing a convertible
bond and selling the underlying stock to create a delta neutral position. The number of shares sold short
usually reflects a delta-neutral or market neutral ratio. It is well known that delta neutral hedging not only
removes small directional risks but also is capable of making a profit on an explosive upside or downside
breakout if the position’s gamma is kept positive. As such, delta neutral hedging is great for uncertain
21
stocks that are expected to make huge breakouts in either direction. Since convertible bonds are issued
mainly by start-up or small companies, the chance of a large movement in either direction is very likely.
Even for very small movements in the underlying stock price, profits can still be generated from the yield
of the convertible bond and the interest rebate for the short position.
We calculate the delta and gamma values for the two deals described in table 1. The Greek vs.
spot equity price graphs are plotted in Figures 2~ 5. It can be seen that the deltas increase with the
underlying stock prices in Figures 2 and 4. At low market levels, the convertibles behave like their
straight bonds with very small deltas. As the stock price increases, conversion becomes more likely. At
certain market levels the convertibles are certain to be converted. In this case, the convertibles are similar
to the underlying equities and the deltas are equal to the number of shares (i.e., conversion ratios).
This graph shows how the delta of the 7-year convertible bond (described in Table 1) changes as the
Figure 3. Variation in gamma vs. spot price for a 7-year convertible bond
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This graph shows how the gamma of the 7-year convertible bond (described in Table 1) changes as the
Figure 4. Delta plotted against changing spot price for a 20-year convertible bond
This graph shows how the delta of the 20-year convertible bond (described in Table 1) changes as the
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Figure 5. Gamma variation with spot price for a 20-year convertible bond
This graph shows how the gamma of the 20-year convertible bond (described in Table 1) changes as the
The gamma diagrams in Figures 3 and 5 have a frown shape. The gammas are the highest when
the convertibles are at-the-money. It is intuitive that when the stock prices rise or fall, profits increase
because of favorably changing deltas. For this reason, convertible bonds are very good candidates for
delta neutral hedging. Relatively large positive gammas of convertibles could be one of the main drivers
5. Conclusion
This paper aims to price hybrid financial instruments (e.g., convertible bonds) whose values may
simultaneously depend on different assets subject to credit risk in a proper and consistent way. The
motivation for our model is that if a company goes bankrupt, all the securities (including the equity) of
the company default. The recovery is realized in accordance with the priority established by the
24
Bankruptcy Code. In other words, different securities have the same probability of default, but different
recovery rates.
Our study shows that risky asset pricing is quite different from risk-free asset pricing. In fact, the
expectation of a defaultable asset actually grows at a risky rate rather than the risk-free rate. This
We propose a hybrid framework to value risky equities and debts in a unified way. The model
relies on the probability distribution of the default jump rather than the default jump itself. As such, the
model can achieve a high order of accuracy with a relatively easy implementation.
find that convertible bonds have relatively large positive gammas, implying that convertible arbitrage can
make a significant profit on a large upside or downside movement in the underlying stock price.
Appendix
In this section, we describe the numerical method used to solve discrete forms of (23) and (28).
St
Let x ln and define backward time as T t . The equations (23) and (28) can be rewritten as
S0
B 1 2 2 B 2 B
r q h (1 ) r h(1 b ) B 0 (A1)
2 x 2 2 x
s
G 1 2 2 G 2 G
r q h (1 ) r h(1 s ) G 0 (A2)
2 x 2 2 x
s
The equations (A1) and (A2) can be approximated using Crank-Nicolson rule. We discretize the x
to be equally spaced as a grid of nodes 0 ~ M. At the maturity, GT and BT are determined according to
(29) and (30). At any time i+1, the boundary conditions are
25
BMi 1 0
i 1 when x (A4)
GM S M
// use the PSOR (Projected Successive over Relaxation) method to obtain the
~
continuation value of the bond component Bt and the continuation value of the equity
~
component Gt , applying the constraints (31).
EndFor
The value at node[0][y] is the convertible bond price where the equity price at node[0][y] is equal
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