*This article appeared in The Edge in Jan 2012*

**By Jasvin Josen**

Convertible
securities are traded widely in global debt markets. The most common
convertible securities are convertible bonds and convertible preferred stocks. The
Convertible Bond (CB) is an equity-linked instrument that gives the holder of
the bond the right to convert the bond into a predetermined number of common
stock in the future. It is attractive to investors as it provides downside
protection of a straight bond with coupons and principal payback at maturity
plus the upside return of equities.

Being
a hybrid of a bond and equity, the price behaviour of a CB is rather unique.
The pricing of CBs is also not very clear-cut. In this article, I describe the
features of the CB and its pricing behaviour and illustrate two common pricing
methods in the market.

**Features of a Convertible Bond**

Suppose Company Q issues a convertible bond with a
conversion ratio of 25.32 shares. The par value of the bond is $1000. This
means that for each $1000 of the par value of this issue that the bondholder
exchanges for Company Q’s stock, he will receive 25.32 shares.

The stated conversion price is therefore:

= Par Value of the CB / Conversion Ratio

= $1000 / 25.32

= $39.49

If this CB pays an annual coupon of 6% with a maturity of 5
years, the CB has an investment value. Assuming the risk free discounting rate
is 2.5% and the credit spread is zero, the Investment Value of the bond can be derived
by discounting its cash flows at the risk free discount rate, as shown in

**Chart 1.**

**Chart 1: Investment Value of Company Q’s Convertible Bond**

Now, the conversion price, realistically, is revised to:

= Investment Value of the CB / Conversion Ratio

= $1162.60 / 25.32

= $45.92

The CB example I provide above is one of its most basic kinds.
Frequently, CBs are accompanied with a redeemable feature that allows the
issuer to call back the bond after a certain period, at a predetermined price.
In some cases the issuer can only call back the bond if the price of the
underlying stock is above the conversion price by a certain percentage. The
callable or redeemable feature makes the CB to some extent cheaper than a
non-redeemable CB.

**Price Behaviour of Convertible Bonds**

The price of the CB is affected by movement in interest
rates (and credit spreads) as well as movements in the stock prices. Taking the
example of Company Q’s CB, there are two extreme cases:

(i)
When the stock price of Q is relatively small to the
conversion price of $45.92, the CB is very unlikely to be converted and
therefore it is effectively a straight bond that can be priced using the
standard bond pricing method.

(ii)
When the stock price is very high relative to the conversion
price, the CB will certainly be converted into stock. The CB price will then be
the

*conversion value*, which is the stock price multiplied by the conversion ratio.
For example, if
the stock price is $60, this CB is very likely to be converted. Its price will
behave very much like the stock. The price of the CB in the market is likely to
be near $1,519.20 (stock price of $60 multiplied by the conversion ratio of
25.32)

Source: Convertible Bonds, Zhi Da (2004)

In

**Chart 2**, the solid line corresponds to the conversion value, which linearly increases with the stock price. The horizontal dashed line corresponds to the price of a straight bond and it is not affected by the stock price. Generally, since you have the option to make the convertible bond either a bond or a stock, its value should be at least the value of the bond or the stock. This is represented by the dotted line.**Pricing a CB as a straight bond plus a call option on the stock**

Intuitively, a CB must be worth at least the value of a
non-convertible bond of similar characteristics. If the holder does not
convert, he will receive the coupons and the principal back. However, the CB is
worth more than this as the holder has a chance in participating in the stock
price movement.

This conversion feature resembles a call option on the
stock. The conversion premium increases as the spot price or the volatility of
the stock increases.

In

**Chart 3**, say the current stock price is $40. This price is not too far from the conversion price (which effectively now is the strike price of the call option) of $45.92. The CB holder effectively is holding the option to buy the stock at $45.92. As the stock price increases beyond $40, we expect the call option to get more expensive.
The call option here is priced using the Black Scholes
model. The parameters are:

Current stock price: $40

Strike Price: $45.92

Risk Free rate: 2.5%

Stock volatility: 20%

Maturity: 5
years

The CB value of $1169.47 is then derived by adding the call option value
of $6.87 to the Investment Value of the Bond of $1162.60.

**Pricing a CB as a stock plus put option on the stock**

Owning a CB can also be seen from another angle. The holder
of the CB will only choose not to convert the CB into stock if the stock price
is below the strike price of $45.92. This is as good as saying that the owner already
has the stock, but has the option to sell the stock if its price goes down
beyond a certain level. In return, he gets the returns from the bond.

**Chart 4: CB priced as a stock plus put option on the stock**

In

**Chart 4**, the stock value is simply the conversion value (stock price of$40 multiplied by the conversion ratio of 25.32). The put option is arrived using the Black Scholes model, with the same parameters used to arrive at the call option on the stock in the first pricing method.

Multiplying the put option value ($7.39) with the conversion
ratio (25.32) would give us the put value embedded in the CB. Indirectly, this put
value represents the fixed income value of the convertible.

**Conclusion**

There are also other more advanced pricing techniques (but
less commonly used) in the market like multi-factor models that take into
account of several stochastic factors that simultaneously affect the price of
the CB, namely interest rates, credit spreads, stock price and in some cases, foreign
exchange rates.

We see that convertibles can be theoretically priced using a
few techniques to resemble their real market prices. However in certain
situations (e.g. in periods of high volatility) theoretical prices can drift
away away from real market prices. This is because the models used to obtain theoretical
prices are subject to many assumptions and are therefore, at best, only an
estimate of the real prices. The real market price is determined by random but
collective behaviour of market players reacting simultaneously to interest
rates, stock price and the issuer’s credit risk.

ReplyDeleteEuropean shares rose on Wednesday, with results-driven gains from German sportswear company Adidas and British security company G4S partly offset by losses from EDF and Boskalis .capitalstars

Unique information on convertible bonds one a learn here. A good knowledge about market and its terminologies helps to frame a better trading strategy. Traders can take help from financial advisory services providers to design optimum trading plans if they are unable to do so.

ReplyDelete