tert8d [7 Quantitative Strategies Research Notes November 1994 Valuing Convertible Bonds as Derivativesrez0d Ee ‘QUANTITATIVE STRATEGIES RESEARCH NOTES ‘©1994 Goldnan, Sache & Co. Al righ reserved, ‘This maueial is for your private information, sad we are not soLciting any action based wpon it Tit report i no to be construe as an offer to sell r the solictaion of an le to buy any security i aay Juradicion where such an offer or soliton ‘would be Stlgad The material is bad open inforastice that we conser relable, bat we & not represen that tis soctrae or complete, kd it showld aot he relied epon as such. Opiaione expresnd ae car cameo opinions sr of thr die appearing om Sie materia ony. ‘While weendeavourto epdate oa a reasomble basis the information dicuszed inthis materia. there may be regulatory. camplince, ‘or oxi reasons that prvert vs from ding so. We and our afte, ffices, dusters, patter, aad employees, iscuding peron involved inthe prepuraon or issuance of is material 8 fem et time, lave long or short postiocs fa, and hay oF ll the secures, or derivatives (insluding option) therof, of companies nentoucd tein. ‘Tis murial nas been issued vy Goldman, Sacts & Co. andlor one of ils affiliates and has been approved by Goldenan Sachs International.» meaner of The Secures and Faure Authority, ke oonneetion with its dstibution in the United Kingdoxn and by Goldoan, Sachs Cama in consecton wit ts distribution in Canada. This mater ic ditrsbuted fn Hong Kong by Goldmar Sache (Asia) Linitd: ad in ipan by Goldman Sachs (apun) Lid. This osteral ie not for disribation in tbe United Kingdom to pate ccusomers, a that term it defined ander tbe rules of The Seemstes and Futures Authority, and soy investacet,iacloding any ‘otveribie bonds or derivatives. mentioned inthis mateal will not be made availabe by uw eny s0c private customer Reiter ‘Geidenan, Sacbe & Co, nor is represataive in Seoul. Keres, is Ieeesod to engage in the eacures busiaess In the Republic of Korea. Goldman Sachs Intention and it aU S afates may. tothe extent ferited wader applicable In bave acted epos oF ‘sed tie research. to the extent it relates © a08-US. issuer, prior to of inunedisely following its publication, Porign-cumeney~ devostinatd seearles are subject to lucuations in excbange rater thal could bave an adverse effect onthe valve er price of, or facome derived fom, ti invesument. In adsition, investors in recanties such as ADRs, Se values of which are sofacnsed by forsign urcocion efecively atime ceri) ris, Farther informa eo any ofthe secures mentioned in dis mera may be ebluned upon request. and for this pinpose perions in Tialy stouldevotat Goldenan Sachs SUM. $p.A. in Mila, of its Londen branch office at 133 Flet Sttet and person ia Mong Kone ould contsct Goldmin Sicht (Aria) Limited at 3 Carden Roud. Unloe governing aw pertite etherwie, Jou mast contact * Goldrnaa Sachs entity in your ome jurisdiction if you want t9 use oar sericea in effecting a transaction in the securies ‘mentioned fo this material ar 6z:et Z6-zt-v9ree0d QUANTITATIVE STRATEGIES RESEARCH NOTES ‘SUMMARY Convertible bonds are derivative securities: they con- tain options on the underlying common stock are the straight debt of their issues, In this paper, we describe ‘a binomial one-factor model for calculating their theo- retical waltue. The model assumes that all uncertainty 4n the future value of a convertible bond stems from the volatility of the underlying stock price. It uses a credit adjusted discount rate when calculating the [present value of future cash flows. in order to account for the credit sensitivity of a convertible. A computer implementation of the model. ealled Hycira, is avail- able from the Quantitative Strategies Group, Indrajit Bardhan (212) 902-5274 Alex Bergicr (212) 902-2944 Emanuel Derman (212) 002-0129 ‘Cemal Dosembet, (219) 902-3886 Iraj Kani (212) 902-2861 Editorial: Barbara Dunn ‘The model described here 1s a descendent of an earlier model developed by Fischer Black and H.S. Huang. as, deseribed in the paper A Valuation Mode! for Optons, Warrants and Convertibles (Goldman, Sache & Co., 1988), We alone are responsible for the waye in which this model differs fom the Black-Huang version. We are grateful to Fischer Black. Charles Eve, Michael Hintze, David Lockwood, Evan Misshula, Allan Teh, Gary Wiliams and Masayoshi Yoshihara for many conversations about the optioas features of coavert- Sbles, We also thank Piotr Karasinskt who worked ‘together with us on this model. ar 6z:et Z6-zt-v9