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Pricing Convertible Bond 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 market is of primary global importance. 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 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. 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 (2013). 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 and recovery rates. 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 profitability in convertible arbitrage. The empirical results show that the model priceIt 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 in the stock price in either direction (Somanath, 2011). 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. Pricing Convertible Bond |