Explain how to value a convertible bond within an arbitrage-free framework
The idea
In an arbitrage-free framework a convertible is broken into components valued separately. A plain convertible is worth its straight value plus a call option on the shares covered by the conversion ratio. If the issuer can call the bond, subtract the issuer's call; if the holder can put it, add the put. So a callable, putable convertible = straight bond + call on shares − issuer call + holder put. Higher share price volatility raises the value of the conversion option; higher interest rate volatility raises both bond options. Because the components interact, practitioners use trees or simulation that model both rates and share prices. Watch the signs of the embedded options.
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- Explain bonds and other debt securities that contain embedded options
- Explain how a callable or putable bond's value links to the value of its embedded option and of the equivalent straight bond
- Explain how to apply the arbitrage-free approach when valuing a bond that contains embedded options
- Explain the effect of interest rate volatility on what a callable or putable bond is worth
- Explain the effect of shifts in the yield curve's level and shape on what a callable or putable bond is worth
- Use an interest rate tree to work out what a callable or putable bond is worth
- Explain how option-adjusted spreads are computed and what they are used for
- Explain the effect of interest rate volatility on option-adjusted spreads
- Work out a callable or putable bond's effective duration and explain what it means
- Contrast the effective durations of straight, callable and putable bonds
- Explain how one-sided and key rate durations help assess the rate sensitivity of bonds that contain embedded options
- Contrast the effective convexities of straight, callable and putable bonds
- Work out what a floating-rate bond with a cap or a floor is worth
- Set out the key characteristics of a convertible bond
- Work out the parts that make up a convertible bond's value and explain what they mean
- Weigh the risk and return profile of a convertible bond against the profiles of a straight bond and the underlying common shares