How do you price a convertible bond?

Value of convertible bond = independent value of straight bond + independent value of conversion option.

What is a convertible bond in finance?

A convertible bond is a fixed-income corporate debt security that yields interest payments, but can be converted into a predetermined number of common stock or equity shares. The conversion from the bond to stock can be done at certain times during the bond’s life and is usually at the discretion of the bondholder.

Why can convertible bonds be issued at a higher price?

When issued, they act just like regular corporate bonds, albeit with a slightly lower interest rate. Because convertibles can be changed into stock and, thus, benefit from a rise in the price of the underlying stock, companies offer lower yields on convertibles.

Why do convertible bonds have lower interest rates?

Convertible bonds offer lower interest rates than comparable conventional bonds, so they’re a cost-effective way for the company to raise money. Their conversion to shares also saves the company cash, although it risks diluting the share price.

What is the minimum price for the convertible bond?

To find the bond floor, one must calculate the present value (PV) of the coupon and principal payments discounted at the straight bond interest rate. So, even if the company’s stock price falls, the convertible bond should trade for a minimum of $884.18.

How do you explain convertible debt?

With convertible debt, a business borrows money from a lender where both parties enter the agreement with the intent (from the outset) to repay all (or part) of the loan by converting it into a certain number of its common shares at some point in the future.

Can you short convertible bonds?

A convertible hedge offsets the underlying stock price movements when purchasing a convertible debt security. A convertible hedge is created by buying a convertible debt security and then shorting the conversion amount of stock.

How are convertible bonds accounted for?

Accounting for Convertibles refers to the accounting of the debt instrument that entitles or provide rights to the holder to convert its holding into a specified number of issuing company’s shares where the difference between the fair value of total securities along with other consideration that is transferred and the …

Which is more attractive to investors a convertible bond or a non convertible bond explain why?

Convertible bonds are an ideal compromise between the two, offering the higher returns commonly found with stocks along with the reduced risk associated with bonds. These lesser-known bonds offer greater choice and flexibility than nonconvertible bonds for investors who prefer greater control over their investments.

How do interest rates affect convertible bonds?

To the extent that a convertible security’s investment value is greater than its conversion value, its price will be likely to increase when interest rates fall and decrease when interest rates rise, as with a fixed income security.

What are the advantages of convertible bonds?

Advantages of Convertible Bonds Companies reduce interest expenses due to lower interest rates. Companies avoid dilutive share issues. Investors enjoy a guaranteed income stream. Downside is limited because the investor can recoup their original investment when the bond matures.

What is the minimum value of the bond?

The minimum value of a convertible bond is the “investment value” of its bond component, which is the present value of future coupon payments and principal repayment from the bond. Because of this fact, a convertible bond should be worth at least as much as the value of its underlying shares.

When is convertible bond financing more appropriate than equity financing?

Deferral of stock dilution If a company is not willing to dilute its stock shares in the short or medium term but is comfortable doing so in the long term, convertible bond financing is more appropriate than equity financing.

What are the valuation frameworks for convertible bonds?

The valuation frameworks for convertible bonds in practice mostly use the GBM stochastic process on the stock price as the underlier. The GBM is the underlying stochastic process used in modeling the stock price in the Black-Scholes model.

What is the minimum conversion price required for convertible notes?

Rule 144A requires that the conversion price of the convertible notes be at least 10\% above the market value of the Capital Markets Practice Group 3 underlying shares, but the market generally supports premiums in excess of 10\% over the market price of the underlying shares and so this is not usually an issue.

What is a reversereverse convertible bond?

Reverse convertible bonds give the issuer an option to either buy back the bond in cash or convert the bond to the equity at a predetermined conversion price and rate at the maturity date.