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Gallen
The Pricing of Convertible Bonds
An Analysis of the French market
Manuel Ammann, Axel H. Kind, Christian Wilde
March 2001 Discussion paper no. 200102
Editor: Prof. Jörg Baumberger
University of St. Gallen
Department of Economics
Bodanstr. 1
CH9000 St. Gallen
Phone ++41 71 224 22 41
Fax ++41 71 224 28 85
Email joerg.baumberger@unisg.ch
Publisher:
Electronic Publication:
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an der Universität St. Gallen
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Phone ++41 71 224 23 00
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The Pricing of Convertible Bonds
An Analysis of the French Market
1
Manuel Ammann, Axel H. Kind, Christian Wilde
Authors‘ addresses: Dr. Manuel Ammann
Axel H. Kind, lic. oec. HSG
Christian Wilde, lic. oec. HSG
University of St. Gallen
Swiss Institute of Banking and Finance
Rosenbergstrasse 52
CH9000 St. Gallen
Tel. ++41 71 224 70 60
Fax ++41 71 224 70 88
Email manuel.ammann@unisg.ch
axel.kind@unisg.ch
christian.wilde@unisg.ch
Website www.sbf.unisg.ch
======================================
1
=All convertible bond time series used in this study were provided by Mace Advisers through UBS Warburg.
We thank Zeno Dürr of UBS Warburg for his assistance in obtaining the data and for very helpful discussions.
Furthermore, we thank Zac Bobolakis, Jörg Baumberger, and seminar participants at the University of St.Gallen
for useful comments.
Abstract
We investigate the pricing performance of three convertible bond pricing models on the
French convertible bond market using daily market prices. We examine a component model
separating the convertible bond into a bond and option component, a method based on the
Margrabe model for pricing exchange options, and a binomialtree model with exogenous
credit risk. All three models are found to deliver theoretical values for the analyzed
convertible bonds that tend to be higher than the observed market prices. The prices
obtained by the binomialtree model are nearest to market prices and the mispricing is no
longer statistically significant for the majority of bonds in our sample. For all models, the
difference between market and model prices is greater for outofthe money convertibles
than for at or inthemoney convertibles.
Keywords
Convertible bonds, pricing, French market, binomial tree, derivatives
JEL Classification
G13, G15
3
Introduction
Convertible bonds are complex and widely used
2
financial instruments combining the
characteristics of stocks and bonds. The possibility to convert the bond into a predetermined
number of stocks offers participation in rising stock prices with limited loss potential, given
that the issuer does not default on its bond obligation. Convertible bonds often contain other
embedded options such as call and put provisions. These options can be specified in various
different ways, further adding to the complexity of the instrument. Especially, conversion and
call opportunities may be restricted to certain periods or stock price conditions and the call
price may vary over time.
The purpose of this study is to investigate whether prices observed on secondary markets are
below the theoretical fair values (obtained by a contingent claims pricing model), as is
believed by many practitioners.
Theoretical research on convertible bond pricing was initiated by Ingersoll (1977a) and
Brennan and Schwartz (1977), who both applied the contingent claims approach to the
valuation of convertible bonds. In their valuation models, the convertible bond price depends
on the firm value as the underlying variable. Brennan and Schwartz (1980) extend their model
by including stochastic interest rates. However, they conclude that the effect of a stochastic
term structure on convertible bond prices is so small that it can be neglected for empirical
purposes. McConnell and Schwartz (1986) develop a pricing model based on the stock value
as stochastic variable. To account for credit risk, they use an interest rate that is grossed up by
a constant credit spread. Noting that credit risk of a convertible bond varies with respect to its
2
The Bank for International Settlements reports an outstanding amount of international convertible bonds of 223.6 billion US dollars (not
including domestic issues) per December 2000. (BIS 2001)
4
moneyness, Tsiveriotis and Fernandes (1998) and Hull (2000) propose an approach that splits
the value of a convertible bond into a stock component and a straight bond component.
Buchan (1998) extends the Brennan and Schwartz (1980) model by allowing senior debt and
implements a Monte Carlo simulation approach to solve the valuation equation.
Despite the large size of international convertible bond markets, very little empirical research
on the pricing of convertible bonds has been undertaken. Previous research in this area was
performed by King (1986), who finds that for 103 American convertible bonds, 90 percent of
his model’s predictions fall within 10 percent of market values. More specifically, his results
suggest that, on average, a slight underpricing exists, i.e., market prices are below model
prices. Using monthly price data, Carayannopoulos (1996) empirically investigates 30
American convertible bonds for a oneyear period beginning in the fourth quarter of 1989.
Using a convertible bond valuation model with Cox, Ingersoll and Ross (1985) stochastic
interest rates, he finds similar results as King (1986): While deep outofthemoney bonds are
underpriced, at or inthemoney bonds are slightly overpriced. Buchan (1997) implements a
firm value model using also a CIR term structure model. In contrast to the above mentioned
studies, she finds that, for 35 Japanese convertible bonds
3
, model prices are slightly below
observed market prices on average.
A drawback of these previous pricing studies is the small number of data points per
convertible bond: Buchan (1997) tests her pricing models only for one calendar day (bonds
priced per March 31, 1994), King (1986) for two days (bonds priced per March 31, 1977, and
December 31, 1977), and Carayannopoulos (1996) for twelve days (one year of monthly
3
All but one bond were outofthemoney on March 31, 1994.
5
data). Our study does not suffer from this limitation because we use almost 18 months of
daily price data.
We examine the French market for convertible bonds because of the availability of accurate
daily market prices. In fact, by international comparison, the French convertible bond market
is characterized by the availability of both high quality data and relatively high liquidity.
Nonetheless, no systematic pricing study for the French convertiblebond market has
previously been undertaken. Our sample includes the 21 most liquid convertible bonds, for
which daily convertible bond data from February 19, 1999, through August 5, 2000, are
analyzed.
We test three pricing models: a simple component model, an exchangeoption model and a
binomialtree model with exogenous credit risk. While the first two models are only rough
approximations, they can serve as very simple benchmark models. The third model, however,
is able to take into account many of the complex characteristics of convertible bonds. The
modelgenerated convertible bond prices are then compared to the market prices of the
investigated convertible bonds.
For all three pricing models tested, underpricing is detected on average. The results of the
binomialtree model are closest to the market prices while the simple component model shows
the biggest deviations. For all convertible bonds, the binomialtree model produces the lowest
prices. Furthermore, it is the only model that generates prices that are not, for the large
majority of bonds, statistically significantly different from market prices. For a few
convertible bonds, even overpricing can be observed, although it is not significant.
A partition of the sample according to the moneyness indicates that the underpricing
decreases for convertible bonds that are further inthemoney. Comparing the degree of
6
underpricing to the maturity of the convertible bonds, we find that, the longer the maturity,
the lower is the market price observed relative to the price generated by the model.
The paper is organized as follows: First, we introduce the models used in the empirical
investigation. Second, we describe the data set and discuss the specific characteristics of the
convertible bonds examined. Finally, we present results of the empirical study comparing
theoretical model prices with observed market prices.
Pricing Models for Convertible Bonds
In the following, three models for pricing convertible bonds are presented. In addition to a
simple component model as it is often used in practice, the Margrabe (1978) method for
pricing exchange options is applied to convertible bonds. As a third and most precise
approach, a binomialtree model with exogenous credit risk is implemented. To facilitate the
description, we use the same notation for all three models:
t = current time
Ω
t
= fair value of the convertible bond
T = maturity of the convertible bond
N = face value of the convertible bond
S
t
= equity price (underlying) at time t
F
t
= investment value (bond floor, pseudofloor) at time t
σ
S,t
= stock volatility at time t
σ
F,t
= volatility of the investment value at time t
ρ
= correlation between F and S
d
S
= continuously compounded dividend yield
c = continuously compounded coupon rate
7
n
t
= conversion ratio at time t
r
t,T
= continuously compounded riskfree interest rate from time t to time T
ξ
t
= credit spread at time t
n
t
S
t
= conversion value at time t
K
t
= early redemption price (call price) at time t
Ξ
t
= call trigger at time t
Θ
t
= safety premium
κ
= final redemption ratio at time T in percentage points of the face value
τ
K
= start of the call period
T
K
= end of the call period
τ
Γ
= start of the conversion period
T
Γ
= end of the conversion period
Component Model
In practice, a popular method for pricing convertible bonds is the component model, also
called the synthetic model. The convertible bond is divided into a straight bond component,
denoted by F
t
, and a call option C
t
on the conversion price S
t
n
t
, with strike price X=F
t
. The
fair value of the two components can be calculated with standard formulas. The model is
therefore straightforward to implement.
The fair value of the straight bond with face value N, a continuously compounded coupon rate
c, and a credit spread ξ
t
is calculated using the discounting formula
( )( ) [ ] ( ) ( )( ) [ ] t T r N t T c r N F
t T t t T t t
− + − ⋅ − + − − + − ⋅ ξ κ ξ
, ,
exp 1 exp .
8
κ is the final repayment ratio, indicating the amount of cash (in percentage of the face value),
which is paid out in case the convertible is held until maturity. Note that the amount of the
coupon payment refers to the face value while the redemption payment at maturity may differ
from the face value.
Given geometric Brownian motion under the riskneutral measure for the stock price, i.e.,
( )
t t S t S T t t
dW S dt S d r dS σ + −
,
, the fair value of the call option C
t
with payoff
( ) , 0
T T
C Max S X − is
( ) ( )
1 , 2
( ) exp exp ( )
t t S r T
C S N d d T t X r T t N d ] − − − ⋅ − − ]
] ]
,
where
( )
2
,
,
1,2
,
ln
2
S t
t
t T S
S t
S
r d T t
X
d
T t
σ
σ
 `
 `
+ − ± ⋅ −
' J
' J
' J
( J
( J
−
Consequently, the fair price of the convertible is given by
t t t
F C + Ω .
This pricing approach has several drawbacks. First, separating the convertible into a bond
component and an option component relies on restrictive assumptions, such as the absence of
embedded options. Callability and putability, for instance, are convertible bond features that
cannot be considered in the above separation. In fact, while the Black and Scholes (1973)
closedform solution for the option part of the convertible is extremely simple to use, it is
only a rough approximation for any but the rather rare plainvanilla bonds.
Second, unlike call options, where the strike price is known in advance, convertible bonds
contain an option component with a stochastic strike price. It is stochastic because the value
of the bond to be delivered in exchange for the shares is usually not known in advance unless
9
conversion is certain not to occur until maturity. In effect, the future strike price depends on
the future development of interest rates and the future credit spread.
Margrabe Model
Margrabe (1978) generalizes the Black and Scholes (1973) option pricing formula to price
options which give the holder the right to exchange an asset B for another asset S. Convertible
bonds can be viewed as the sum of a straight bond F plus an option giving the holder the right
to exchange the straight bond F for a certain amount of stocks, S n⋅ . Under the assumption
that geometric Brownian motion is a realistic process for straight bonds, the Margrabe
formula can be applied to pricing convertibles. Since both the price of a straight bond and the
price of a Margrabe option can be determined, the fair value of the convertible bond can be
calculated by simply adding the two components.
Given two correlated Brownian motions under the riskneutral probability measure, W
S
and
W
F
with correlation coefficient ρ, we assume that
( )
,
S
t t T S t S t t
dS r d S dt S dW σ − + for the
stock and
( )
,
F
t t T t F t t
dF r c Fdt FdW σ − + for the straight bond. Then the fair value of the
Margrabe option
S F→
Ψ with payoff ( ) 0 ,
T T T
F S Max − Ψ is
( ) [ ] ( ) [ ] t T c d N F t T d d N S
t S t t
− − − − − Ψ exp ) ( exp ) (
2 1
,
where
( )
t T
t T d c
F
S
d
S
t
t
−
−
J
J
J
`
'
'
(

± − +
J
J
J
`
'
'
(

σ
σ
2
ln
2
2 , 1
and
t F t S t F t S t , ,
2
,
2
,
2 σ ρσ σ σ σ − + .
10
On the other hand, the fair value of the straight bond with face value N, a continuously
compounded coupon c and a credit spread ξ
t
is calculated using the discounting formula
( )( ) [ ] ( ) ( )( ) [ ] t T r N t T c r N F
t T t t T t t
− + − ⋅ − + − − + − ⋅ ξ κ ξ
, ,
exp 1 exp .
κ is the final repayment ratio, indicating the amount of cash (in percentage of the face value)
paid out if the convertible is held until maturity. Consequently, the fair price of the
convertible is given by
t t t
F + Ψ Ω .
The Margrabe method is in so far superior to the simple component model as it models the
stochastic behavior of the bond component. In particular, the correlation ρ of the two
processes is taken into account.
Unfortunately, this model also presents some drawbacks. First, the Margrabe option is
European, but almost all convertible bonds can be exercised prior to maturity. As long as the
coupon rate is less than the dividend yield, this is not a problem. As Subrahmanyam (1990)
points out, it is suboptimal to exercise a Margrabe option prior to maturity if there is a so
called “yield advantage”, i.e., the cash flows of the exchangeable instrument is greater than
the cash flows of the obtained asset at each point.
Second, the option component of the convertible is calculated using an inflexible closedform
solution. Similar to the component model introduced previously, additional embedded options
such as callability or putability features cannot be modeled at all.
Third, geometric Brownian motion is not necessarily a realistic assumption for the straight
bond process although, for longmaturity bonds, the distributional implications of using
geometric Brownian motion may not present a problem. However, the empirical observation
of meanreverting interest rates is not taken into account.
11
BinomialTree Model with Exogenous Credit Risk
Specifying the binomial tree
To price convertibles with a wide range of contractual specifications, we implement a Cox,
Ross and Rubinstein (1979) univariate binomialtree model. Every pricing result is performed
using one hundred steps. For the calculation of the tree, a terminal condition and three
boundary conditions have to be satisfied.
The terminal condition is given by ( ) ,
T T T
Max n S N κ Ω ⋅ , where n
T
is the conversion ratio,
i.e. the number of stocks the bond can be exchanged for, κ is the final repayment ratio, and N
is the face value of the convertible. This condition is considered for all endnodes in the tree.
The following three boundary conditions are necessary due to the earlyexercisable embedded
options. Because of the American character of the instrument, it is necessary to check them in
each node of the tree.
The conversion boundary condition implies that
t t t
S n ⋅ ≥ Ω [ ]
Γ Γ
∈ ∀ T t , τ .
During the conversion period, the value of the convertible cannot be less than the conversion
value; otherwise, an arbitrage opportunity would exist.
The call boundary condition states that whenever
t t t
S n Ξ > is satisfied,
( )
t t t t t
S n Max ⋅ Θ + Κ ≤ Ω , [ ]
Κ Κ
∈ ∀ T t , τ
must hold. K
t
is the relevant call price at time t. Θ
t
is a safety premium that accounts for the
empirical fact, described by Ingersoll (1977b), that the issuer usually does not call
immediately when K
t
is triggered. Firms may want the conversion value to exceed the call
price by a certain amount to safely assure it will still exceed the call price at the end of the call
12
notice period, which normally is three months in the French market. The safety premium is
set equal to zero in this study, resulting in a conservative valuation of the convertible bonds.
The price of a convertible bond cannot, at the same time, be higher than the conversion value
and higher than the call price. If such a situation occurred, the issuer could realize arbitrage
gains by calling the convertible.
The put boundary condition requires that
t t
p ≥ Ω , [ ]
p p
T t
,
τ ∈ ∀ .
p
t
is the relevant put price at time t. If the convertible price were below the relevant put price,
the investor could exercise the put option and realize a risk free gain. Since put features are
absent in our sample of convertible bonds, the put boundary condition does not affect the
results of this analysis.
In each node, it is necessary to check whether each boundary condition is satisfied and to
determine the implications on the value of the convertible bond with respect to the optimal
calling behavior of the issuer and the optimal conversion behavior of the investor
4
.
Figure 1 shows a computationally efficient way of checking the validity of the boundary
conditions and the effects on the convertible bond. There are four possible outcomes: The
convertible bond continues to exist without being called or converted. Alternatively, it may be
called by the issuer, converted by the holder, or called by the issuer and subsequently
converted by the investor. The last scenario is often called forced conversion because the
investor is induced to convert exclusively by the fact that the issuer has called the bond.
When pricing convertible bonds, a dilution effect has to be taken into account. Because, in
most cases, new shares are created upon conversion, the equity value is divided among a
4
For a discussion on the optimal call and conversion policy, see Ingersoll (1977a).
13
higher number of shares. This effect is mitigated (but not canceled) because the liabilities of
the firm are reduced as the convertible debt ceases to exist after conversion. In order to price
convertibles correctly, it is necessary to adjust the stock price in the model downwards.
Dilution is only relevant in the nodes A and F of the flow chart, when the investor decides to
convert. In this study, the dilution effect may be overestimated because we assume that the
green shoe option was always exercised in full when the bond was issued and that the bond is
always converted into newly issued stocks.
Integration of Credit Risk
The classical convertible bond pricing articles of Ingersoll (1977a) and Brennan and Schwartz
(1977) use the firm value as a stochastic variable. This approach allows for rigorous modeling
of credit risk and dilution but is very hard to implement empirically because the firm value is
not observable.
Ingersoll (1977a) and Brennan and Schwartz (1977) assume a simplistic capital structure,
consisting solely of equity and convertible bonds. In reality, such a capital structure is rather
rare. Brennan and Schwartz (1980) adapt the terminal and boundary conditions to cope with
the problem of the existence of senior debt. What seems an elegant way of solving the capital
structure problem in theory can be very hard to implement in practice. As a practical way of
solving this problem, King (1986) suggests to subtract the value of all senior debt positions
from the firm value and to assume this variable to follow geometric Brownian motion.
Unfortunately, this procedure does not take into account the stochastic character of the senior
debt. For convertible bonds of companies with relatively large senior debt issues, this pricing
procedure can be a rather rough approximation.
McConnell and Schwartz (1986) present a pricing model based on the stock value as
stochastic variable. Since the stock price cannot become negative, it is impossible to simulate
14
bankruptcy scenarios. In other words, the model architecture is not capable of accounting for
credit risk in a natural way. However, convertible bonds are especially popular with lower
rated issuers. Therefore, credit risk is a very important aspect of convertible bond pricing. To
account for credit risk, McConnell and Schwartz (1986) use an interest rate that is “grossed up
to capture the default risk of the issuer” (pp. 567) rather than the riskfree rate. This solution,
however, leaves open many questions about its quantification because the credit risk of a
convertible bond varies with respect to its moneyness.
For this reason, Tsiveriotis and Fernandes (1998) and Hull (2000) propose an approach that
splits the value of a convertible bond into a stock component and a straight bond component.
These two components belong to different credit risk categories. The former is riskfree
because a company is always able to deliver its own stock. The latter, however, is risky
because coupon and principal payments depend on the issuer’s capability of distributing the
required cash amounts. It is straightforward to discount the stock part of the convertible with
the riskfree interest rate and the straight bond component with a riskadjusted rate. On the
contrary, the McConnell and Schwartz (1986) procedure produces a pooling between the two
components, as if the ratio of the two parts were constant. In reality, however, the relative
weight of the bond component can vary dramatically. On the one hand, when the convertible
bond is deep in the money, its value should be discounted using the riskfree rate. On the
other hand, when the bond is out of the money, the straight bond component is very high and
so is its defaultable part. This strategy is an improvement over the McConnell and Schwartz
(1986) approach because it clearly identifies the defaultable part of the convertible and thus
its credit risk exposure. We therefore adopt this approach in incorporating a constant
15
exogenous credit spread into our binomialtree model
5
. The appropriate credit spread is given
by the difference between the yield to maturity of a straight bond of the company and the
yield to maturity of a riskfree sovereign bond. The bonds have to be comparable, i.e. they
must have similar seniority, coupon and maturity. If no straight bond comparable to the
convertible exists, the credit spread can be estimated using the rating of the issuing firm.
Data
Convertible Bonds
Because convertible bonds are often traded overthecounter, finding reliable time series of
market prices can be difficult. Even when electronic systems are in use, the delivered prices
are often not the quotes at which the actual trades occur. Additionally, synchronic market
prices of the stocks for which the convertible bonds can be exchanged are needed for this
study. We found these data requirements best satisfied for the French market. Moreover, the
French convertible bond market is one the most liquid European convertible bond markets
with a fair number of large convertible bond issues. We therefore chose the French market for
this pricing study.
We consider all French convertible bonds outstanding as of August 5, 2000. Daily convertible
bond prices as well as the corresponding synchronic stock prices are available from February
19, 1999, through August 5, 2000.
6
5
It could be argued that credit risk increases with decreasing stock price. Since our credit spread is assumed to be constant, our model does
not take this negative correlation into account.
6
Data source: Mace Advisers.
16
To exclude illiquid issues from the sample, we require every issue to satisfy three conditions
cumulatively
7
:
 a minimum market capitalisation of USD 75 million,
 a minimum average exchange traded volume reported to Autex for the last two quarters of
the equivalent of USD 75 million,
 at least three market makers out of the top ten convertible underwriters quoting prices
with a maximum bid/ask spread of 2 percentage points.
In addition, crosscurrency convertibles are excluded from the sample. As a result, our
convertible bond universe consists of 21 French franc/eurodenominated issues with a total of
6760 data points. Table 1 gives an overview of the analyzed convertible bonds. All the
contractual specifications are extracted from the official and legally binding „offering
circulars“. This proved to be necessary because almost every electronic database tends to
suffer from an overstandardization syndrome. Although most bonds in our sample have very
similar specifications, some contractual provisions are so specific that they can hardly be
collected in predefined data types.
Several convertibles in our sample are “premium redemption” convertibles, i.e. the
redemption at maturity is above par value. In this case, the final redemption is given by κN
with the final redemption ratio κ greater than 1.
In the analyzed sample, there are seven exchangeable bonds. In these cases, the issuing firm
and the firm into the stock of which the bond can be converted are not the same firms.
7
These requirements are the same that UBS Warburg utilizes as exit criteria for its convertible bond index family.
17
20 of the 21 analyzed convertibles include a call option, allowing the issuer to repurchase the
bond for a certain price K
t
, called “call price” or “early redemption price”. This price varies
over time. Usually, the call price K
t
is determined in such a way that the holder of the bond
obtains a similar return as when holding the convertible bond until maturity without
converting.
For almost all examined convertibles, early redemption is restricted to a certain predetermined
period from τ
K
to T
K
. The period during which callability is not allowed is called the “call
protection period“. An additional restriction to callability in form of a supplementary
condition to be satisfied is given by the “call condition”. Callability is only allowed if the
parity n
t
S
t
exceeds a “call trigger” Ξ
t
8
. The call trigger is calculated as a percentage of either
the early redemption price or the face value (see Table 2). The last column shows, for each
bond, which of the two methods applies. If the trigger feature is present, the callability is
called “provisional” or “soft” call, if it is absent the callability is “absolute” or
“unconditional”. For almost all convertibles, the trigger feature is present. Only the bond
issued by Suez Lyonnaise des Eaux lacks a trigger and has an unconditional callability.
Another special case is Infograme Entertainment, which has a timevarying call trigger:
Within the period from May 30, 2000, to June 30, 2003, the call trigger is set at 250% of the
early redemption price. After July 1, 2003, the call trigger is reduced to 125% of the early
redemption price. For calculation in the binomialtree model, we use the latter value.
Consequently, the model price may underestimate the fair value of this particular convertible
bond.
8
The exact contractual specification of the call condition often states that the inequality ntSt>Ξt must hold for a certain time (often 30 days)
before the bond becomes callable. This “qualifying period” introduces a path dependent feature not considered in the analysis.
18
Usually, the conversion ratio
t
n is constant over time. It changes in case of an alteration of the
nominal value of the shares (stock subdivisions or consolidations), extraordinary dividend
payments and other financial operations that directly affect the stock price.
Conversion is possible within a certain period, called conversion period. The conversion
period starts at time τ
Γ
and ends at time T
Γ
. For all the issues in our sample, the end of the
conversion period coincides with the maturity of the convertible bond, i.e. T
Γ
= T.
Dilution has been calculated on the basis of the number of shares outstanding
9
and the number
of bonds to be issued as specified in the offering circulars. In twelve cases a “green shoe”
option was present, allowing the underwriter to increase the overall number of bonds. Because
we do not have any information regarding the exercise of the green shoe, we use the
maximum number of bonds (green shoe fully exercised) to estimate the dilution effect. Table
2 exhibits the number of bonds issued and the size of the green shoe option.
Interest Rates
For interest rates of one year or less (7 days, 1, 2, 3, 6, 12 months), we use Eurofranc rates
10
.
For longer maturities (110 years), we extract spot rates from swap rates using the standard
procedure. We observed that the oneyear Eurofranc rate was systematically lower than the
corresponding oneyear swap rate. Under the assumption that the Eurofranc rates represent a
better proxy for the theoretical credit riskfree rates, we adjust down the swapextracted term
structure by the difference between the oneyear Eurofranc rate and the oneyear swap rate.
Furthermore, we use linear interpolation to obtain the complete continuous term structure of
spot rates.
9
Data source: Primark Datastream.
19
Unobservable Parameters
Besides directly observable input parameters, such as stock prices and interest rates, the
pricing models require input parameters that have to be estimated and thus are a source of
estimation error. These variables include volatility, dividends, correlations and credit spreads.
The most important input parameter to be estimated is the volatility of the underlying stock
price. Research on stock volatility estimation is plentiful. A popular approach is the implied
volatility concept. With option pricing formulas, it is possible to extract market participants’
volatility estimations from atthemoney option prices. However, most liquid options have
shorter maturities than convertibles. We therefore estimate volatility on a historical basis. The
relevant volatility is calculated as the standard deviation of the returns of the last 520 trading
days.
We model future dividends using a continuously compounded dividend yield. More precisely,
we assume that the best estimator for future dividends is the ratio of the current dividend
11
level and the stock price. Furthermore, we assume that this ratio is constant over time.
The Margrabe model requires the correlation between the straight bond and the stock as an
input variable. Unfortunately, straight bonds with the same characteristics (coupon, maturity,
seniority) as the convertible bond are very rarely available. For this reason, we calculate the
correlation using time series of stock price and the theoretical investment value. The
investment value denotes the value of the convertible bond under the hypothetical assumption
that the conversion option does not exist.
10
All interest rate data is obtained from Primark Datastream.
11
Dividend information is obtained from Primark Datastream.
20
Table 1 shows the mean credit spread expressed in basis points over the relevant period
12
.
Where the issuer has straight debt in the market, the credit spread is calculated on the basis of
the traded yield spread. Otherwise, it is calculated on the basis of credit spread indices, e.g.
the Bloomberg Fair Market Curves and UBS Credit Indices, according to the characteristics
of the sector in the relevant rating category.
Results
The observed convertible bond prices on the French market are compared with theoretical
prices obtained with three convertible bond pricing models. The main results of the three
implemented models are summarized
13
in Table 4, Table 5, and Table 6. In analogy to the
methodology used by Sterk (1982) and others to test option pricing formulas, the tables
provide data about the maximum, minimum and mean percentage overpricing of each issue.
The mean percentage overpricing is presented for each convertible bond as an average of the
deviation between the theoretical and observed price for each observation. A negative value
indicates an underpricing, i.e. the theoretical value is above the observed market price.
Additionally, the probability values of a test for the null hypothesis of a mean overpricing of
zero are presented for each convertible. The last column shows the root mean squared error of
the relative mispricing. The RMSE shows the noncentral standard deviation of the relative
deviations of model prices from market prices. It can be interpreted as a measure for the
pricing fit of the model relative to market prices.
With all three models, we observe on average substantially lower market prices than
theoretical prices. We obtain the largest underpricing for the component model (8.74%),
12
We thank Rupert Kenna, credit analyst at UBS Warburg in London, for providing the daily credit spread time series.
13
Pricing results for each individual convertible bond are graphically displayed in the appendix.
21
followed by the Margrabe model (5.60%). The binomialtree model is closest to the market
prices, but exhibits an average underpricing of 2.78%. This underpricing prevails even
though we value the convertible bond conservatively by assuming maximum dilution and
setting the safety premium to zero. For almost all convertibles, the binomialtree model
produces the lowest theoretical price, followed by the Margrabe and the component model.
The only exception is the LVMHconvertible, where the overvaluation detected by the
Margrabe model is slightly higher than that of the binomialtree model.
The binomialtree model is the only model that in the entire sample detects cases of
overpricing. Among those five cases, the overpricing ranges from 3.78% (Usinor 2006) to
0.47% (Vivendi 2005). However, the mispricing is not significantly different from zero at a
five percent level. In contrast, sixteen convertible bonds have a mean percentage
underpricing. The significance test indicates that the mean price deviation of five of them is
significantly different from zero. Even though the overall theoretical pricing of the binomial
tree model is close to the market data, the maximum and minimum percentage overpricing for
each convertible that occurred during the observation period often is very different. In some
cases, this may be caused by data outliers, which have not been removed in this study.
Prices calculated with the Margrabe model are substantially higher than both market prices
and theoretical binomialtree prices, representing an underpricing for each convertible bond.
This can be explained by the fact that the model does not account for the call feature, which is
present in all but one of the examined convertible bonds. Callability reduces the stockdriven
upwardpotential and thus has a negative impact on convertible prices.
For the component model, the mean percentage deviations from market prices are
significantly different from zero for 16 of the 21 convertible bonds, all of which are
overpriced by the model. Model prices are biased upwards because of two reasons: As in the
22
Margrabe model, callability is neglected. Second, the strike price remains constant instead of
growing at a rate equal to the difference between interest rate and coupon. This distortion is
larger the longer the maturity of the bond and the lower the coupon rate is.
The fact that convertibles can be converted before maturity of the bond is accounted for
neither by the component model nor by the Margrabe model. This effect is of opposite
direction to the omission of the call feature. For eight convertibles in our sample, the dividend
yield is higher than the coupon rate. This is of interest, because it may make early conversion
optimal in a world of continuously compounded dividend yields and coupon rates.
Figure 2 exhibits the overpricing of the observed market prices as detected by the binomial
tree model plotted against the moneyness. The relationship is nonlinear. The model
overprices bonds that are atthemoney and outofthe money and underprices inthemoney
convertibles. These results are similar to those obtained by Carayannopoulos (1996). There
seems to be a slight relationship between overpricing and maturity (see Figure 3). The longer
the time to maturity, the more convertibles tend to be underpriced. However, these results rely
heavily on only two bonds (Axa 2014 and Axa 2017) that have a maturity far longer than the
others.
These results are similar for the other models. The relationship between overpricing and
moneyness is also positive. However, the relationship between overpricing and maturity is
slightly more negative for the component model. This finding is consistent with the above
mentioned fact that the component model tends to overprice bonds with long maturities and
with coupon rates below the interest rate level.
23
Conclusion
We undertake a pricing study for the French convertible bond market. A simple component
model, a model based on exchange options, and a binomialtree model are implemented.
Unlike the first two models, the binomialtree model incorporates embedded options, dilution,
and credit risk. The modelgenerated prices are compared to the market prices of the
investigated convertible bonds using a sample of convertible bond prices of nearly 18 months
of daily data. For all three pricing models, on average, underpricing is detected. The results of
the binomialtree model are closest to the market prices while the simple component model
has the greatest deviation. For all convertible bonds, the binomialtree model gives the lowest
prices. Moreover, for the majority of bonds in our sample, the underpricing is not significant
for this model. A partition of the sample according to the moneyness indicates that the
underpricing is decreasing for bonds that are further inthemoney. Our findings of
underpricing, particularly for outofthemoney bonds, are consistent with two previous
studies for the American market and anecdotal evidence from traders and other convertible
bond practitioners.
24
References
BIS (2001), Bank for International Settlements Quarterly Review, March, pp. 71.
BLACK, F., and M. SCHOLES (1973): “The Pricing of Options and Corporate Liabilities”,
Journal of Political Economy, 81, 637654.
BRENNAN, M.J., and E.S. SCHWARTZ (1977): “Convertible Bonds: Valuation and
Optimal Strategies for Call and Conversion”, The Journal of Finance, 32 (5), 1699
1715.
BRENNAN, M.J., and E.S. SCHWARTZ (1980): “Analyzing Convertible Bonds”, Journal of
Financial and Quantitative Analysis, 15 (4), 907929.
BUCHAN, J. (1997):”Convertible Bond Pricing: Theory and Evidence”, Unpublished
Dissertation, Harvard University.
BUCHAN, J. (1998):”The Pricing of Convertible Bonds with Stochastic Term Structures and
Corporate Default Risk”, Working Paper, Amos Tuck School of Business, Dartmouth
College.
CARAYANNOPOULOS, P. (1996): “Valuing Convertible Bonds under the Assumption of
Stochastic Interest Rates: An Empirical Investigation”, Quarterly Journal of Business
and Economics, 35 (3), 1731.
COX, J.C., S.A. ROSS and M. RUBINSTEIN (1979): “Option Pricing: A simplified
Approach”, Journal of Financial Economics, 7 (3), 229263.
HULL, J.C. (2000): Options, Futures & Other Derivatives. PrenticeHall, Upper Saddle
River, N.Y., 4
th
ed.
25
INGERSOLL, J.E. (1977a): “A Contingent Claim Valuation of Convertible Securities”,
Journal of Financial Economics, 4, 289322.
INGERSOLL, J.E. (1977b): “An examination of corporate call policy on convertible
securities”, Journal of Finance, 32, 463478.
KING, R. (1986): “Convertible Bond Valuation: An Empirical Test”, Journal of Financial
Research, 9 (1), 5369.
MARGRABE, W (1978): “The Value of an Option to Exchange One Asset for Another”,
Journal of Finance, 33 (1), 177186.
McCONNELL, J.J., and E.S. SCHWARTZ (1986): “LYON Taming”, The Journal of
Finance, 41 (3), 561576.
STERK, W. (1982): “Tests of Two Models for Valuing Call Options on Stocks with
Dividends”, The Journal of Finance, 37 (5), 12291237.
SUBRAHMANYAM, M.G. (1990): “The Early Exercise Feature of American Options” in
FIGLEWSKI, S., W.L. SILBER and M.G. SUBRAHMANYAM (1990): “Financial
Options – From Theory to Practice”, Irwin, Burr Ridge, Illinois.
TSIVERIOTIS, K., and C. FERNANDES (1998): “Valuing Convertible Bonds with Credit
Risk”, The Journal of Fixed Income, 8 (3), 95102.
26
Figures and Tables
Figure 1: Flow chart of optimal option exercise
yes
no
yes
Does the
Investor want
to convert?
t t t
S n ⋅ < Ω
Are we within
the conversion
period?
conversion
Are we within
the call period?
[ ]
K K
T t , τ ∈
Is the
callcondition
satisfied?
t t t
S n Ξ >
Does the issuer
want to call?
t t t
K Θ + > Ω
Does the
investor want to
convert?
t t t
S n Κ >
yes
no
yes
yes
yes
conversion
(forced)
continuation of the
convertible bond
no
no
no
no
Early
redemption
[ ]
Γ Γ
∈ T t , τ
A
B
C
F
E
D
27
Table 1: Specification of the convertible bonds
Exchangeable into shares of Company Maturity Coupon Pricing points
Axa Finaxa 2007 3.00% 404
Axa Suez Lyonnaise des Eaux 2004 0.00% 397
Axa Axa 2014 2.50% 404
Axa Axa 2017 3.75% 150
Bouygues Bouygues 2006 1.70% 404
Bull Bull 2005 2.25% 90
Carrefour (Promodès) Carrefour (Promodès) 2004 2.50% 257
France Télécom France Télécom 2004 2.00% 404
Infogrames Entertainment Infogrames Entertainment 2005 1.50% 80
LVMH Financiere Agache 2004 0.00% 377
Peugeot Peugeot 2001 2.00% 404
PinaultPrintempsRedoute Artemis 2005 1.50% 404
PinaultPrintempsRedoute PinaultPrintempsRedoute 2003 1.50% 321
Rhodia Aventis (RhônePoulenc) 2003 3.25% 234
Scor Scor 2005 1.00% 321
Société Générale Société Vinci Obligations 2003 1.50% 404
Total Fina Belgelec Finance 2004 1.50% 316
Usinor Usinor 2006 3.00% 464
Usinor Usinor 2005 3.88% 150
Vivendi Vivendi 2004 1.25% 404
Vivendi Vivendi 2005 1.50% 366
28
Table 2: Specification of embedded options.
The “call trigger ratio” can refer to either the face value of the convertible or to the early redemption price
(denoted as “redemption”). “Maximum number of convertibles” indicates the highest number of bonds issued
according to the offering circular (including green shoe, if present). The “green shoe” option indicates the
number of convertible bonds that could be issued on a discretionary basis. Zero means that no green shoe was
present.
Issuing company Initial
conversion
ratio
Final
Redemption
ratio
Callability Call
trigger
ratio
Call
trigger
basis
Maximum
number of
convertibles
“Green
shoe”
option
Finaxa 1 118.18% no   13‘037‘878 0
Suez Lyonnaise des Eaux 1 109.83% yes   54‘655‘022 0
Axa 1 139.93% yes 125.00% redemption 9‘239‘333 1‘205‘129
Axa 1 162.63% yes 125.00% redemption 7‘643‘502 996‘978
Bouygues 1 100.00% yes 115.00% redemption 1‘905‘490 152‘440
Bull 1 116.60% yes 120.00% redemption 11‘491‘752 1‘495‘752
Carrefour (Promodès) 1 100.00% yes 120.00% redemption 589‘471 0
France Télécom 10 100.00% yes 115.00% face value 2‘538‘543 250‘000
Infogrames Entertainment 1 118.23% yes 250.00% redemption 10‘282‘744 1‘341‘227
Financiere Agache 1 111.77% yes 120.00% face value 1‘724‘137 0
Peugeot 1 123.64% yes 100.00% redemption 4‘000‘000 0
Artemis 10 110.54% yes 120.00% face value 200‘000 0
PinaultPrintempsRedoute 1 103.63% yes 130.00% redemption 4‘784‘688 382‘774
Aventis (RhônePoulenc) 1 100.00% yes 130.00% redemption 43‘685‘260 0
Scor 1 112.55% yes 120.00% redemption 4‘025‘000 525‘000
Société Vinci Obligations 1 100.00% yes 130.00% redemption 1‘828‘620 0
Belgelec Finance 1 100.00% yes 130.00% redemption 7‘550‘300 0
Usinor 1 110.91% yes 125.00% redemption 29‘761‘904 3‘571‘427
Usinor 1 100.00% yes 130.00% redemption 25‘000‘000 3‘000‘000
Vivendi 1 100.00% yes 115.00% redemption 6‘028‘369 709‘220
Vivendi 1 106.27% yes 115.00% redemption 11‘070‘111 1‘476‘015
29
Table 3: Statistics of the input parameters used
Convertibles Mean of the input
volatility
Mean of the input
dividend yield
Mean credit spread
(in basis points)
Correlation
stock/bond
Axa 2007 35.85% 2.18% 45 0.260
Axa 2004 35.89% 2.19% 40 0.208
Axa 2014 35.85% 2.18% 73 0.233
Axa 2017 36.58% 2.16% 74 0.142
Bouygues 46.08% 1.00% 84 0.022
Bull 66.05% 0.00% 300 0.024
Carrefour 37.58% 0.97% 42 0.016
F. Télécom 46.45% 1.69% 31 0.061
Infogrames 56.16% 0.00% 300 0.020
LVMH 39.95% 1.62% 80 0.138
Peugeot 39.61% 1.89% 40 0.086
Pinault 2005 38.99% 1.29% 100 0.101
Pinault 2003 38.93% 1.29% 80 0.071
Rhodia 45.07% 4.09% 59 0.009
Scor 39.12% 5.75% 26 0.022
S. Générale 45.04% 3.94% 50 0.071
Total Fina 39.29% 2.79% 50 0.029
Usinor 2006 45.66% 5.46% 124 0.020
Usinor 2005 44.86% 5.46% 119 0.033
Vivendi 2004 32.06% 1.98% 75 0.085
Vivendi 2005 32.37% 2.00% 82 0.077
30
Table 4: Pricing overview for the binomialtree model
“Data points” indicates the number of days for which model prices are computed. “Probability values” is a two
sided test for the H
0
hypothesis that model prices and observed prices are equal in the mean. The “root mean
squared error” is the noncentral standard deviation of the relative deviations of model prices from market prices.
Convertibles Data
points
Maximum
percentage
overpricing
Minimum
percentage
overpricing
Mean
percentage
overpricing
Probability
values
Root mean
squared error
Axa 2007 402 5.83% 5.42% 0.58% 0.72974 0.018
Axa 2004 396 4.23% 7.56% 0.56% 0.77267 0.020
Axa 2014 402 5.19% 10.08% 3.37% 0.31523 0.048
Axa 2017 149 2.55% 13.34% 8.71% 0.00000 0.089
Bouygues 402 21.84% 9.76% 1.40% 0.68053 0.037
Bull 89 9.75% 16.81% 14.07% 0.00000 0.142
Carrefour 256 7.99% 10.87% 1.46% 0.59718 0.031
F. Télécom 402 23.92% 18.97% 1.60% 0.66270 0.040
Infogrames 78 8.49% 14.36% 11.72% 0.00000 0.118
LVMH 376 0.62% 9.65% 4.76% 0.06953 0.054
Peugeot 402 18.39% 2.78% 2.46% 0.31557 0.035
Pinault 2005 402 0.00% 8.67% 3.73% 0.04404 0.042
Pinault 2003 320 5.41% 6.40% 2.39% 0.37238 0.036
Rhodia 232 0.32% 13.00% 5.40% 0.17815 0.067
Scor 320 9.88% 2.67% 0.67% 0.72626 0.020
S. Générale 402 3.74% 5.19% 1.61% 0.30344 0.022
Total Fina 315 3.64% 4.82% 1.60% 0.18626 0.020
Usinor 2006 402 17.51% 4.51% 3.78% 0.18799 0.047
Usinor 2005 149 3.51% 11.11% 8.13% 0.00000 0.082
Vivendi 2004 402 6.64% 3.83% 0.28% 0.86665 0.017
Vivendi 2005 364 7.66% 3.72% 0.47% 0.79780 0.019
Mean 5.33% 8.34% 2.78%
31
Table 5: Pricing overview for the Margrabe model
Convertibles Data
points
Maximum
percentage
overpricing
Minimum
percentage
overpricing
Mean
percentage
overpricing
Probability
values
Root mean
squared error
Axa 2007 402 6.31% 6.00% 0.96% 0.60801 0.021
Axa 2004 396 2.75% 11.46% 5.92% 0.00000 0.061
Axa 2014 402 6.18% 12.57% 3.99% 0.28587 0.055
Axa 2017 149 3.96% 15.71% 10.91% 0.00000 0.111
Bouygues 402 19.47% 13.34% 4.05% 0.31338 0.057
Bull 89 14.05% 21.58% 18.11% 0.00000 0.182
Carrefour 256 3.13% 15.25% 3.54% 0.18826 0.044
F. Télécom 402 20.19% 20.19% 4.72% 0.22397 0.061
Infogrames 78 9.83% 15.79% 13.25% 0.00000 0.133
LVMH 376 0.12% 10.31% 4.68% 0.11763 0.056
Peugeot 402 9.15% 7.25% 3.08% 0.17344 0.038
Pinault 2005 402 3.37% 13.29% 7.84% 0.00063 0.082
Pinault 2003 320 5.01% 6.70% 2.79% 0.29575 0.039
Rhodia 232 1.04% 15.09% 7.17% 0.08908 0.083
Scor 320 8.15% 3.96% 0.82% 0.66133 0.020
S. Générale 402 2.89% 6.15% 2.41% 0.14604 0.029
Total Fina 315 3.10% 6.05% 2.62% 0.04180 0.029
Usinor 2006 402 17.58% 8.26% 0.79% 0.87443 0.050
Usinor 2005 149 6.34% 14.66% 11.79% 0.00000 0.119
Vivendi 2004 402 4.65% 4.92% 1.83% 0.24055 0.024
Vivendi 2005 364 4.57% 6.82% 2.18% 0.20149 0.028
Mean 3.14% 10.70% 5.16%
32
Table 6: Pricing overview for the component model
Convertibles Data
points
Maximum
percentage
overpricing
Minimum
percentage
overpricing
Mean
percentage
overpricing
Probability
values
Root mean
squared error
Axa 2007 402 1.36% 10.58% 5.53% 0.00189 0.058
Axa 2004 396 6.72% 17.15% 11.05% 0.00000 0.112
Axa 2014 402 0.52% 19.66% 11.20% 0.00647 0.119
Axa 2017 149 8.29% 19.40% 14.88% 0.00000 0.150
Bouygues 402 15.16% 17.60% 8.09% 0.06020 0.092
Bull 89 17.43% 24.66% 21.23% 0.00000 0.213
Carrefour 256 0.49% 18.00% 6.54% 0.01473 0.071
F. Télécom 402 16.62% 22.40% 7.43% 0.03818 0.083
Infogrames 78 16.04% 21.52% 19.05% 0.00000 0.191
LVMH 376 6.49% 14.25% 10.41% 0.00001 0.107
Peugeot 402 7.72% 8.48% 4.28% 0.06345 0.049
Pinault 2005 402 5.69% 17.89% 11.67% 0.00009 0.120
Pinault 2003 320 3.51% 7.97% 4.18% 0.09978 0.049
Rhodia 232 2.47% 16.11% 8.51% 0.03784 0.094
Scor 320 2.67% 8.51% 5.36% 0.00267 0.056
S. Générale 402 1.43% 8.67% 5.00% 0.00891 0.054
Total Fina 315 1.52% 8.82% 6.24% 0.00000 0.064
Usinor 2006 402 13.40% 11.32% 3.92% 0.40018 0.061
Usinor 2005 149 7.93% 15.55% 12.99% 0.00000 0.131
Vivendi 2004 402 0.95% 10.13% 6.45% 0.00002 0.066
Vivendi 2005 364 1.70% 11.02% 7.71% 0.00000 0.078
Mean 0.61% 14.08% 8.71%
33
Figure 2: Moneyness/overpricing relationship for
the binomialtree model
Figure 3: Maturity/overpricing relationship for the
binomialtree model
Table 7: Pricing statistics of the
binomialtree model for different
moneyness classes
Moneyness Mean
Overpricing
Overpricing
std.
Probability
values
< 0.80 5.67% 0.052 0.27805
0.80 – 0.95 1.63% 0.038 0.66970
0.95 – 1.05 1.56% 0.036 0.66399
1.05 – 1.20 1.88% 0.044 0.67048
1.20 – 2.00 1.19% 0.036 0.73767
> 2.00 0.38% 0.036 0.91594
Table 8: Pricing statistics of the
binomialtree model for different
maturity classes
Maturity
(trading days)
Mean
Overpricing
Overpricing
std.
Probability
values
< 500 0.31% 0.035 0.92895
500 – 1000 1.00% 0.028 0.71704
1000 – 1500 2.47% 0.042 0.55897
1500 – 2500 0.34% 0.034 0.92101
> 2500 4.82% 0.038 0.20917
34
Figure 4: Moneyness/overpricing relationship
for the component model
Figure 5: Maturity/overpricing relationship
for the component model
Table 9: Pricing statistics of the component
model for different moneyness classes
Moneyness Mean
overpricing
Overpricing
std.
Probability
values
< 0.80 10.35% 0.062 0.09389
0.80 – 0.95 7.19% 0.038 0.05918
0.95 – 1.05 7.94% 0.040 0.04975
1.05 – 1.20 8.70% 0.051 0.09094
1.20 – 2.00 8.03% 0.038 0.03423
> 2.00 4.89% 0.035 0.16323
Table 10: Pricing statistics of the component
model for different maturity classes
Maturity
(trading days)
Mean
overpricing
Overpricing
std.
Probability
values
< 500 4.24% 0.024 0.07898
500 – 1000 6.69% 0.029 0.01996
1000 – 1500 9.02% 0.044 0.03819
1500 – 2500 6.16% 0.040 0.12380
> 2500 12.20% 0.040 0.00227
35
Figure 6: Moneyness/overpricing relationship
for the Margrabe model
Figure 7: Maturity/overpricing relationship
for the Margrabe model
Table 11: Pricing statistics of the Margrabe
model for different moneyness classes
Moneyness Mean
overpricing
Overpricing
std.
Probability
values
< 0.80 8.67% 0.057 0.13116
0.80 – 0.95 3.67% 0.038 0.32918
0.95 – 1.05 4.68% 0.038 0.21270
1.05 – 1.20 4.71% 0.044 0.28808
1.20 – 2.00 3.50% 0.032 0.27432
> 2.00 1.03% 0.036 0.77283
Table 12: Pricing statistics of the Margrabe
model for different maturity classes
Maturity
(trading days)
Mean
overpricing
Overpricing
std.
Probability
values
< 500 2.95% 0.025 0.22896
500 – 1000 3.19% 0.027 0.23156
1000 – 1500 4.98% 0.045 0.27271
1500 – 2500 2.34% 0.040 0.56080
> 2500 5.87% 0.046 0.19742
36
Appendix
0 50 100 150 200 250 300 350 400 450
60
80
100
120
140
160
180
trading days
v
a
l
u
e
s
pricing of the Axa 2007, 3% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350 400 450
0.06
0.04
0.02
0
0.02
0.04
0.06
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Axa 2007, 3% convertible
0 50 100 150 200 250 300 350 400
100
110
120
130
140
150
160
170
180
190
trading days
v
a
l
u
e
s
pricing of the Axa 2004, 0% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350 400
0.08
0.06
0.04
0.02
0
0.02
0.04
0.06
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Axa 2004, 0% convertible
0 50 100 150 200 250 300 350 400 450
100
110
120
130
140
150
160
170
180
190
200
trading days
v
a
l
u
e
s
pricing of the Axa 2014, 2.5% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350 400 450
0.12
0.1
0.08
0.06
0.04
0.02
0
0.02
0.04
0.06
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Axa 2014, 2.5% convertible
0 50 100 150
120
130
140
150
160
170
180
190
200
210
220
trading days
v
a
l
u
e
s
pricing of the Axa 2017, 3.75% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150
0.14
0.12
0.1
0.08
0.06
0.04
0.02
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Axa 2017, 3.75% convertible
37
0 50 100 150 200 250 300 350 400 450
100
200
300
400
500
600
700
800
900
1000
trading days
v
a
l
u
e
s
pricing of the Bouygues 2006, 1.7% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350 400 450
0.1
0.05
0
0.05
0.1
0.15
0.2
0.25
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Bouygues 2006, 1.7% convertible
0 10 20 30 40 50 60 70 80 90
6
8
10
12
14
16
18
20
trading days
v
a
l
u
e
s
pricing of the Bull 2005, 2.25% convertible
theoretical fair value
empirical value
parity
investment value
0 10 20 30 40 50 60 70 80 90
0.17
0.16
0.15
0.14
0.13
0.12
0.11
0.1
0.09
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Bull 2005, 2.25% convertible
0 50 100 150 200 250 300
700
800
900
1000
1100
1200
1300
trading days
v
a
l
u
e
s
pricing of the Carrefour 2004, 2.5% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300
0.12
0.1
0.08
0.06
0.04
0.02
0
0.02
0.04
0.06
0.08
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Carrefour 2004, 2.5% convertible
0 50 100 150 200 250 300 350 400 450
600
800
1000
1200
1400
1600
1800
2000
2200
trading days
v
a
l
u
e
s
pricing of the France Télécom 2004, 2% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350 400 450
0.2
0.15
0.1
0.05
0
0.05
0.1
0.15
0.2
0.25
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the France Télécom 2004, 2% convertible
38
0 10 20 30 40 50 60 70 80
20
25
30
35
40
45
50
trading days
v
a
l
u
e
s
pricing of the Infogrames Entertainment 2005, 1.5% convertible
theoretical fair value
empirical value
parity
investment value
0 10 20 30 40 50 60 70 80
0.15
0.14
0.13
0.12
0.11
0.1
0.09
0.08
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Infogrames Entertainment 2005, 1.5% convertible
0 50 100 150 200 250 300 350 400
200
250
300
350
400
450
500
550
trading days
v
a
l
u
e
s
pricing of the LVMH 2004, 0% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350 400
0.1
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the LVMH 2004, 0% convertible
0 50 100 150 200 250 300 350 400 450
100
150
200
250
trading days
v
a
l
u
e
s
pricing of the Peugeot 2001, 2% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350 400 450
0.05
0
0.05
0.1
0.15
0.2
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Peugeot 2001, 2% convertible
0 50 100 150 200 250 300 350 400 450
1200
1400
1600
1800
2000
2200
2400
2600
2800
3000
trading days
v
a
l
u
e
s
pricing of the PinaultPrintemps 2005, 1.5% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350 400 450
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
0.01
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the PinaultPrintemps 2005, 1.5% convertible
39
0 50 100 150 200 250 300 350
140
160
180
200
220
240
260
280
300
trading days
v
a
l
u
e
s
pricing of the PinaultPrintemps 2003, 1.5% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350
0.08
0.06
0.04
0.02
0
0.02
0.04
0.06
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the PinaultPrintemps 2003, 1.5% convertible
0 50 100 150 200 250
15
20
25
30
trading days
v
a
l
u
e
s
pricing of the Rhodia 2003, 3.25% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
0.02
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Rhodia 2003, 3.25% convertible
0 50 100 150 200 250 300 350
40
45
50
55
60
65
trading days
v
a
l
u
e
s
pricing of the Scor 2005, 1% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350
0.04
0.02
0
0.02
0.04
0.06
0.08
0.1
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Scor 2005, 1% convertible
0 50 100 150 200 250 300 350 400 450
120
140
160
180
200
220
240
260
280
300
trading days
v
a
l
u
e
s
pricing of the Société Générale 2003, 1.5% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350 400 450
0.06
0.05
0.04
0.03
0.02
0.01
0
0.01
0.02
0.03
0.04
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Société Générale 2003, 1.5% convertible
40
0 50 100 150 200 250 300 350
110
120
130
140
150
160
170
180
190
200
trading days
v
a
l
u
e
s
pricing of the Total Fina 2004, 1.5% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350
0.05
0.04
0.03
0.02
0.01
0
0.01
0.02
0.03
0.04
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Total Fina 2004, 1.5% convertible
0 50 100 150 200 250 300 350 400 450
10
12
14
16
18
20
22
trading days
v
a
l
u
e
s
pricing of the Usinor 2006, 3% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350 400 450
0.05
0
0.05
0.1
0.15
0.2
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Usinor 2006, 3% convertible
0 50 100 150
10
12
14
16
18
20
22
24
trading days
v
a
l
u
e
s
pricing of the Usinor 2005, 3.875% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150
0.12
0.11
0.1
0.09
0.08
0.07
0.06
0.05
0.04
0.03
trading days
o
v
e
r
v
a
l
u
a
t
i
o
n
percentage overvaluation of the Usinor 2005, 3.875% convertible
0 50 100 150 200 250 300 350 400 450
150
200
250
300
350
400
450
trading days
v
a
l
u
e
s
pricing of the Vivendi 2004, 1.25% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350 400 450
0.04
0.02
0
0.02
0.04
0.06
0.08
trading days
o
v
e
r
v
a
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u
a
t
i
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n
percentage overvaluation of the Vivendi 2004, 1.25% convertible
41
0 50 100 150 200 250 300 350 400
150
200
250
300
350
400
450
trading days
v
a
l
u
e
s
pricing of the Vivendi 2005, 1.5% convertible
theoretical fair value
empirical value
parity
investment value
0 50 100 150 200 250 300 350 400
0.04
0.02
0
0.02
0.04
0.06
0.08
trading days
o
v
e
r
v
a
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u
a
t
i
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percentage overvaluation of the Vivendi 2005, 1.5% convertible
Editor:
Publisher:
Electronic Publication:
Prof. Jörg Baumberger University of St. Gallen Department of Economics Bodanstr. 1 CH9000 St. Gallen Phone ++41 71 224 22 41 Fax ++41 71 224 28 85 Email joerg.baumberger@unisg.ch Forschungsgemeinschaft für Nationalökonomie an der Universität St. Gallen Dufourstrasse 48 CH9000 St. Gallen Phone ++41 71 224 23 00 Fax ++41 71 224 26 46 www.fgn.unisg.ch/public/public.htm
The Pricing of Convertible Bonds
An Analysis of the French Market1
Manuel Ammann, Axel H. Kind, Christian Wilde
Authors‘ addresses:
Dr. Manuel Ammann Axel H. Kind, lic. oec. HSG Christian Wilde, lic. oec. HSG University of St. Gallen Swiss Institute of Banking and Finance Rosenbergstrasse 52 CH9000 St. Gallen Tel. ++41 71 224 70 60 Fax ++41 71 224 70 88 Email manuel.ammann@unisg.ch axel.kind@unisg.ch christian.wilde@unisg.ch Website www.sbf.unisg.ch
======================================
1
=All convertible bond time series used in this study were provided by Mace Advisers through UBS Warburg.
We thank Zeno Dürr of UBS Warburg for his assistance in obtaining the data and for very helpful discussions. Furthermore, we thank Zac Bobolakis, Jörg Baumberger, and seminar participants at the University of St.Gallen for useful comments.
Abstract We investigate the pricing performance of three convertible bond pricing models on the French convertible bond market using daily market prices. We examine a component model separating the convertible bond into a bond and option component, a method based on the Margrabe model for pricing exchange options, and a binomialtree model with exogenous credit risk. All three models are found to deliver theoretical values for the analyzed convertible bonds that tend to be higher than the observed market prices. The prices obtained by the binomialtree model are nearest to market prices and the mispricing is no longer statistically significant for the majority of bonds in our sample. For all models, the difference between market and model prices is greater for outofthe money convertibles than for at or inthemoney convertibles. Keywords Convertible bonds, pricing, French market, binomial tree, derivatives JEL Classification G13, G15
conversion and call opportunities may be restricted to certain periods or stock price conditions and the call price may vary over time. given that the issuer does not default on its bond obligation. further adding to the complexity of the instrument. the convertible bond price depends on the firm value as the underlying variable. McConnell and Schwartz (1986) develop a pricing model based on the stock value as stochastic variable. Brennan and Schwartz (1980) extend their model by including stochastic interest rates.Introduction Convertible bonds are complex and widely used2 financial instruments combining the characteristics of stocks and bonds. These options can be specified in various different ways. Convertible bonds often contain other embedded options such as call and put provisions. they use an interest rate that is grossed up by a constant credit spread. In their valuation models. The possibility to convert the bond into a predetermined number of stocks offers participation in rising stock prices with limited loss potential. To account for credit risk. The purpose of this study is to investigate whether prices observed on secondary markets are below the theoretical fair values (obtained by a contingent claims pricing model). Especially. they conclude that the effect of a stochastic term structure on convertible bond prices is so small that it can be neglected for empirical purposes.6 billion US dollars (not including domestic issues) per December 2000. However. Theoretical research on convertible bond pricing was initiated by Ingersoll (1977a) and Brennan and Schwartz (1977). as is believed by many practitioners. (BIS 2001) 3 . Noting that credit risk of a convertible bond varies with respect to its 2 The Bank for International Settlements reports an outstanding amount of international convertible bonds of 223. who both applied the contingent claims approach to the valuation of convertible bonds.
Carayannopoulos (1996) empirically investigates 30 American convertible bonds for a oneyear period beginning in the fourth quarter of 1989. his results suggest that.moneyness..or inthemoney bonds are slightly overpriced. Ingersoll and Ross (1985) stochastic interest rates. Previous research in this area was performed by King (1986). he finds similar results as King (1986): While deep outofthemoney bonds are underpriced. and Carayannopoulos (1996) for twelve days (one year of monthly 3 All but one bond were outofthemoney on March 31. Buchan (1998) extends the Brennan and Schwartz (1980) model by allowing senior debt and implements a Monte Carlo simulation approach to solve the valuation equation. Using monthly price data. who finds that for 103 American convertible bonds. she finds that. Tsiveriotis and Fernandes (1998) and Hull (2000) propose an approach that splits the value of a convertible bond into a stock component and a straight bond component. market prices are below model prices. and December 31. In contrast to the above mentioned studies. More specifically. King (1986) for two days (bonds priced per March 31. i. 90 percent of his model’s predictions fall within 10 percent of market values. a slight underpricing exists. Using a convertible bond valuation model with Cox. 4 . on average. Buchan (1997) implements a firm value model using also a CIR term structure model. 1977). very little empirical research on the pricing of convertible bonds has been undertaken. for 35 Japanese convertible bonds3. Despite the large size of international convertible bond markets. 1994.e. 1977. model prices are slightly below observed market prices on average. at. A drawback of these previous pricing studies is the small number of data points per convertible bond: Buchan (1997) tests her pricing models only for one calendar day (bonds priced per March 31. 1994).
by international comparison. Our sample includes the 21 most liquid convertible bonds. A partition of the sample according to the moneyness indicates that the underpricing decreases for convertible bonds that are further inthemoney. Our study does not suffer from this limitation because we use almost 18 months of daily price data. although it is not significant. The modelgenerated convertible bond prices are then compared to the market prices of the investigated convertible bonds. 2000. through August 5. 1999. they can serve as very simple benchmark models.data). The results of the binomialtree model are closest to the market prices while the simple component model shows the biggest deviations. For all three pricing models tested. it is the only model that generates prices that are not. For a few convertible bonds. is able to take into account many of the complex characteristics of convertible bonds. While the first two models are only rough approximations. Furthermore. no systematic pricing study for the French convertiblebond market has previously been undertaken. Nonetheless. even overpricing can be observed. the binomialtree model produces the lowest prices. the French convertible bond market is characterized by the availability of both high quality data and relatively high liquidity. statistically significantly different from market prices. The third model. for the large majority of bonds. underpricing is detected on average. We test three pricing models: a simple component model. In fact. however. We examine the French market for convertible bonds because of the availability of accurate daily market prices. Comparing the degree of 5 . are analyzed. For all convertible bonds. an exchangeoption model and a binomialtree model with exogenous credit risk. for which daily convertible bond data from February 19.
a binomialtree model with exogenous credit risk is implemented. Second. The paper is organized as follows: First. To facilitate the description. we find that. In addition to a simple component model as it is often used in practice. three models for pricing convertible bonds are presented.underpricing to the maturity of the convertible bonds. we introduce the models used in the empirical investigation. Pricing Models for Convertible Bonds In the following. we present results of the empirical study comparing theoretical model prices with observed market prices. we describe the data set and discuss the specific characteristics of the convertible bonds examined.t = stock volatility at time t σF.t = volatility of the investment value at time t ρ dS c = correlation between F and S = continuously compounded dividend yield = continuously compounded coupon rate 6 . we use the same notation for all three models: t = current time = fair value of the convertible bond = maturity of the convertible bond = face value of the convertible bond = equity price (underlying) at time t = investment value (bond floor. the longer the maturity. Finally. As a third and most precise approach. the Margrabe (1978) method for pricing exchange options is applied to convertible bonds. pseudofloor) at time t Ωt T N St Ft σS. the lower is the market price observed relative to the price generated by the model.
The convertible bond is divided into a straight bond component.T = continuously compounded riskfree interest rate from time t to time T ξt = credit spread at time t ntSt = conversion value at time t Kt = early redemption price (call price) at time t = call trigger at time t = safety premium = final redemption ratio at time T in percentage points of the face value = start of the call period = end of the call period = start of the conversion period = end of the conversion period Ξt Θt κ τK TK τΓ TΓ Component Model In practice.T + ξt − c )(T − t )] + N (κ − 1) ⋅ exp[− (rt .T + ξt )(T − t )]. a continuously compounded coupon rate c. 7 . with strike price X=Ft.nt = conversion ratio at time t rt. The model is therefore straightforward to implement. also called the synthetic model. and a call option Ct on the conversion price Stnt. The fair value of the straight bond with face value N. a popular method for pricing convertible bonds is the component model. The fair value of the two components can be calculated with standard formulas. denoted by Ft. and a credit spread ξt is calculated using the discounting formula Ft = N ⋅ exp[− (rt .
for instance. First. dS t = (rt . i. where S ln t X 2 σ S . It is stochastic because the value of the bond to be delivered in exchange for the shares is usually not known in advance unless 8 . indicating the amount of cash (in percentage of the face value).t T − t d1.. Second.t + rt . This pricing approach has several drawbacks. the fair value of the call option Ct with payoff CT = Max ( ST − X . In fact. 0 ) is Ct = St N (d1 ) exp − d S (T − t ) − X ⋅ exp − rr . convertible bonds contain an option component with a stochastic strike price. while the Black and Scholes (1973) closedform solution for the option part of the convertible is extremely simple to use. Note that the amount of the coupon payment refers to the face value while the redemption payment at maturity may differ from the face value. where the strike price is known in advance. the fair price of the convertible is given by Ω t = C t + Ft .2 = ⋅ (T − t ) Consequently. separating the convertible into a bond component and an option component relies on restrictive assumptions.T − d S )S t dt + σ S S t dWt . it is only a rough approximation for any but the rather rare plainvanilla bonds. are convertible bond features that cannot be considered in the above separation.T (T − t ) N (d 2 ) . unlike call options.κ is the final repayment ratio. Callability and putability.e. which is paid out in case the convertible is held until maturity. Given geometric Brownian motion under the riskneutral measure for the stock price.T − d S ± 2 σ S . such as the absence of embedded options.
T − d S ) St dt + σ S St dWt stock and dFt = ( rt . In effect. 2 and 2 2 σ t = σ S . we assume that dSt = ( rt .T − c ) Ft dt + σ F Ft dWt F S for the for the straight bond. Then the fair value of the Margrabe option ΨF →S with payoff ΨT = Max(S T − FT .conversion is certain not to occur until maturity.t + σ F . Since both the price of a straight bond and the price of a Margrabe option can be determined. Convertible bonds can be viewed as the sum of a straight bond F plus an option giving the holder the right to exchange the straight bond F for a certain amount of stocks. where S ln t F = t σ2 + c − dS ± (T − t ) 2 σ T −t d 1. Given two correlated Brownian motions under the riskneutral probability measure. 9 . the fair value of the convertible bond can be calculated by simply adding the two components. WS and WF with correlation coefficient ρ.t . Under the assumption that geometric Brownian motion is a realistic process for straight bonds.0) is Ψt = S t N (d 1 ) exp[− d S (T − t )] − Ft N (d 2 ) exp[− c(T − t )] . Margrabe Model Margrabe (1978) generalizes the Black and Scholes (1973) option pricing formula to price options which give the holder the right to exchange an asset B for another asset S.t − 2 ρσ S . n ⋅ S . the future strike price depends on the future development of interest rates and the future credit spread.t σ F . the Margrabe formula can be applied to pricing convertibles.
Consequently. the option component of the convertible is calculated using an inflexible closedform solution. indicating the amount of cash (in percentage of the face value) paid out if the convertible is held until maturity.. a continuously compounded coupon c and a credit spread ξt is calculated using the discounting formula Ft = N ⋅ exp[− (rt . the correlation ρ of the two processes is taken into account. but almost all convertible bonds can be exercised prior to maturity. The Margrabe method is in so far superior to the simple component model as it models the stochastic behavior of the bond component. As long as the coupon rate is less than the dividend yield.On the other hand.T + ξ t − c )(T − t )] + N (κ − 1) ⋅ exp[− (rt . the cash flows of the exchangeable instrument is greater than the cash flows of the obtained asset at each point. As Subrahmanyam (1990) points out. Unfortunately. it is suboptimal to exercise a Margrabe option prior to maturity if there is a so called “yield advantage”. the distributional implications of using geometric Brownian motion may not present a problem. additional embedded options such as callability or putability features cannot be modeled at all. the Margrabe option is European. First. Second. geometric Brownian motion is not necessarily a realistic assumption for the straight bond process although.e. for longmaturity bonds. the empirical observation of meanreverting interest rates is not taken into account. the fair value of the straight bond with face value N. 10 . However. Third.T + ξ t )(T − t )] . Similar to the component model introduced previously. this model also presents some drawbacks. κ is the final repayment ratio. In particular. this is not a problem. i. the fair price of the convertible is given by Ωt = Ψt + Ft .
where nT is the conversion ratio. Kt is the relevant call price at time t. This condition is considered for all endnodes in the tree. The following three boundary conditions are necessary due to the earlyexercisable embedded options. a terminal condition and three boundary conditions have to be satisfied. i. an arbitrage opportunity would exist. For the calculation of the tree. Ω t ≤ Max(Κ t + Θ t . The terminal condition is given by ΩT = Max ( nT ST . The call boundary condition states that whenever nt St > Ξ t is satisfied. that the issuer usually does not call immediately when Kt is triggered. the value of the convertible cannot be less than the conversion value. κ ⋅ N ) . During the conversion period. the number of stocks the bond can be exchanged for. it is necessary to check them in each node of the tree. Every pricing result is performed using one hundred steps.e. Because of the American character of the instrument. Θt is a safety premium that accounts for the empirical fact. The conversion boundary condition implies that Ωt ≥ nt ⋅ St ∀t ∈ [τ Γ . Ross and Rubinstein (1979) univariate binomialtree model. and N is the face value of the convertible. TΚ ] must hold. nt ⋅ S t ) ∀t ∈ [τ Κ .BinomialTree Model with Exogenous Credit Risk Specifying the binomial tree To price convertibles with a wide range of contractual specifications. κ is the final repayment ratio. described by Ingersoll (1977b). we implement a Cox. TΓ ] . otherwise. Firms may want the conversion value to exceed the call price by a certain amount to safely assure it will still exceed the call price at the end of the call 11 .
be higher than the conversion value and higher than the call price. a dilution effect has to be taken into account. the investor could exercise the put option and realize a risk free gain. When pricing convertible bonds. new shares are created upon conversion. or called by the issuer and subsequently converted by the investor. The last scenario is often called forced conversion because the investor is induced to convert exclusively by the fact that the issuer has called the bond. The safety premium is set equal to zero in this study. it is necessary to check whether each boundary condition is satisfied and to determine the implications on the value of the convertible bond with respect to the optimal calling behavior of the issuer and the optimal conversion behavior of the investor4. at the same time. Since put features are absent in our sample of convertible bonds. The price of a convertible bond cannot. it may be called by the issuer. If such a situation occurred. ∀t ∈ τ p . The put boundary condition requires that Ωt ≥ pt . resulting in a conservative valuation of the convertible bonds. which normally is three months in the French market. pt is the relevant put price at time t. see Ingersoll (1977a). There are four possible outcomes: The convertible bond continues to exist without being called or converted. If the convertible price were below the relevant put price. Figure 1 shows a computationally efficient way of checking the validity of the boundary conditions and the effects on the convertible bond.T p [ ]. the put boundary condition does not affect the results of this analysis. converted by the holder. the equity value is divided among a 4 For a discussion on the optimal call and conversion policy.notice period. in most cases. the issuer could realize arbitrage gains by calling the convertible. In each node. Because. 12 . Alternatively.
In order to price convertibles correctly. Dilution is only relevant in the nodes A and F of the flow chart. King (1986) suggests to subtract the value of all senior debt positions from the firm value and to assume this variable to follow geometric Brownian motion. What seems an elegant way of solving the capital structure problem in theory can be very hard to implement in practice. McConnell and Schwartz (1986) present a pricing model based on the stock value as stochastic variable. This approach allows for rigorous modeling of credit risk and dilution but is very hard to implement empirically because the firm value is not observable. In this study. Ingersoll (1977a) and Brennan and Schwartz (1977) assume a simplistic capital structure. As a practical way of solving this problem. such a capital structure is rather rare. Since the stock price cannot become negative.higher number of shares. the dilution effect may be overestimated because we assume that the green shoe option was always exercised in full when the bond was issued and that the bond is always converted into newly issued stocks. Integration of Credit Risk The classical convertible bond pricing articles of Ingersoll (1977a) and Brennan and Schwartz (1977) use the firm value as a stochastic variable. this pricing procedure can be a rather rough approximation. when the investor decides to convert. it is necessary to adjust the stock price in the model downwards. this procedure does not take into account the stochastic character of the senior debt. Brennan and Schwartz (1980) adapt the terminal and boundary conditions to cope with the problem of the existence of senior debt. For convertible bonds of companies with relatively large senior debt issues. it is impossible to simulate 13 . consisting solely of equity and convertible bonds. Unfortunately. In reality. This effect is mitigated (but not canceled) because the liabilities of the firm are reduced as the convertible debt ceases to exist after conversion.
the model architecture is not capable of accounting for credit risk in a natural way. when the bond is out of the money.bankruptcy scenarios. 567) rather than the riskfree rate. however. On the other hand. To account for credit risk. Therefore. when the convertible bond is deep in the money. In other words. This solution. convertible bonds are especially popular with lowerrated issuers. On the contrary. its value should be discounted using the riskfree rate. These two components belong to different credit risk categories. the straight bond component is very high and so is its defaultable part. McConnell and Schwartz (1986) use an interest rate that is “grossed up to capture the default risk of the issuer” (pp. The latter. however. leaves open many questions about its quantification because the credit risk of a convertible bond varies with respect to its moneyness. the relative weight of the bond component can vary dramatically. In reality. however. We therefore adopt this approach in incorporating a constant 14 . However. For this reason. is risky because coupon and principal payments depend on the issuer’s capability of distributing the required cash amounts. as if the ratio of the two parts were constant. credit risk is a very important aspect of convertible bond pricing. The former is riskfree because a company is always able to deliver its own stock. Tsiveriotis and Fernandes (1998) and Hull (2000) propose an approach that splits the value of a convertible bond into a stock component and a straight bond component. On the one hand. This strategy is an improvement over the McConnell and Schwartz (1986) approach because it clearly identifies the defaultable part of the convertible and thus its credit risk exposure. It is straightforward to discount the stock part of the convertible with the riskfree interest rate and the straight bond component with a riskadjusted rate. the McConnell and Schwartz (1986) procedure produces a pooling between the two components.
Daily convertible bond prices as well as the corresponding synchronic stock prices are available from February 19. 6 Data source: Mace Advisers. the French convertible bond market is one the most liquid European convertible bond markets with a fair number of large convertible bond issues. through August 5. the delivered prices are often not the quotes at which the actual trades occur. synchronic market prices of the stocks for which the convertible bonds can be exchanged are needed for this study. If no straight bond comparable to the convertible exists. We found these data requirements best satisfied for the French market. We therefore chose the French market for this pricing study. coupon and maturity. they must have similar seniority. The bonds have to be comparable.e. Additionally. our model does not take this negative correlation into account. The appropriate credit spread is given by the difference between the yield to maturity of a straight bond of the company and the yield to maturity of a riskfree sovereign bond. 2000. Since our credit spread is assumed to be constant.6 5 It could be argued that credit risk increases with decreasing stock price. Moreover. the credit spread can be estimated using the rating of the issuing firm. i.exogenous credit spread into our binomialtree model5. 15 . finding reliable time series of market prices can be difficult. Data Convertible Bonds Because convertible bonds are often traded overthecounter. Even when electronic systems are in use. 2000. We consider all French convertible bonds outstanding as of August 5. 1999.
Several convertibles in our sample are “premium redemption” convertibles. at least three market makers out of the top ten convertible underwriters quoting prices with a maximum bid/ask spread of 2 percentage points. there are seven exchangeable bonds. the redemption at maturity is above par value. we require every issue to satisfy three conditions cumulatively7: a minimum market capitalisation of USD 75 million. 7 These requirements are the same that UBS Warburg utilizes as exit criteria for its convertible bond index family. In addition. the issuing firm and the firm into the stock of which the bond can be converted are not the same firms.e. Although most bonds in our sample have very similar specifications.To exclude illiquid issues from the sample. 16 . In these cases. some contractual provisions are so specific that they can hardly be collected in predefined data types. Table 1 gives an overview of the analyzed convertible bonds. our convertible bond universe consists of 21 French franc/eurodenominated issues with a total of 6760 data points. As a result. a minimum average exchange traded volume reported to Autex for the last two quarters of the equivalent of USD 75 million. crosscurrency convertibles are excluded from the sample. In the analyzed sample. In this case. All the contractual specifications are extracted from the official and legally binding „offering circulars“. This proved to be necessary because almost every electronic database tends to suffer from an overstandardization syndrome. i. the final redemption is given by κN with the final redemption ratio κ greater than 1.
20 of the 21 analyzed convertibles include a call option. Usually. called “call price” or “early redemption price”. we use the latter value. For calculation in the binomialtree model. the call trigger is set at 250% of the early redemption price. This price varies over time. If the trigger feature is present. After July 1. to June 30. 2000. the callability is called “provisional” or “soft” call. For almost all convertibles. 8 The exact contractual specification of the call condition often states that the inequality ntSt>Ξt must hold for a certain time (often 30 days) before the bond becomes callable. the call trigger is reduced to 125% of the early redemption price. the call price Kt is determined in such a way that the holder of the bond obtains a similar return as when holding the convertible bond until maturity without converting. This “qualifying period” introduces a path dependent feature not considered in the analysis. 17 . allowing the issuer to repurchase the bond for a certain price Kt. The call trigger is calculated as a percentage of either the early redemption price or the face value (see Table 2). The period during which callability is not allowed is called the “call protection period“. 2003. For almost all examined convertibles. which of the two methods applies. which has a timevarying call trigger: Within the period from May 30. Another special case is Infograme Entertainment. Consequently. for each bond. Callability is only allowed if the parity ntSt exceeds a “call trigger” Ξt8. The last column shows. An additional restriction to callability in form of a supplementary condition to be satisfied is given by the “call condition”. Only the bond issued by Suez Lyonnaise des Eaux lacks a trigger and has an unconditional callability. 2003. the trigger feature is present. the model price may underestimate the fair value of this particular convertible bond. if it is absent the callability is “absolute” or “unconditional”. early redemption is restricted to a certain predetermined period from τK to TK.
For all the issues in our sample. we use the maximum number of bonds (green shoe fully exercised) to estimate the dilution effect. 18 . we use Eurofranc rates10. we adjust down the swapextracted term structure by the difference between the oneyear Eurofranc rate and the oneyear swap rate. Conversion is possible within a certain period. TΓ = T.Usually. 1. In twelve cases a “green shoe” option was present. Under the assumption that the Eurofranc rates represent a better proxy for the theoretical credit riskfree rates. the end of the conversion period coincides with the maturity of the convertible bond. we extract spot rates from swap rates using the standard procedure. Dilution has been calculated on the basis of the number of shares outstanding9 and the number of bonds to be issued as specified in the offering circulars. Furthermore.e. 3. 6. extraordinary dividend payments and other financial operations that directly affect the stock price. the conversion ratio nt is constant over time. called conversion period. 2. It changes in case of an alteration of the nominal value of the shares (stock subdivisions or consolidations). we use linear interpolation to obtain the complete continuous term structure of spot rates. allowing the underwriter to increase the overall number of bonds. Interest Rates For interest rates of one year or less (7 days. 12 months). Because we do not have any information regarding the exercise of the green shoe. Table 2 exhibits the number of bonds issued and the size of the green shoe option. For longer maturities (110 years). The conversion period starts at time τΓ and ends at time TΓ. We observed that the oneyear Eurofranc rate was systematically lower than the corresponding oneyear swap rate. i. 9 Data source: Primark Datastream.
10 All interest rate data is obtained from Primark Datastream. straight bonds with the same characteristics (coupon.Unobservable Parameters Besides directly observable input parameters. we assume that this ratio is constant over time. With option pricing formulas. The Margrabe model requires the correlation between the straight bond and the stock as an input variable. Furthermore. Research on stock volatility estimation is plentiful. However. For this reason. We therefore estimate volatility on a historical basis. 11 19 . the pricing models require input parameters that have to be estimated and thus are a source of estimation error. These variables include volatility. we assume that the best estimator for future dividends is the ratio of the current dividend11 level and the stock price. correlations and credit spreads. We model future dividends using a continuously compounded dividend yield. More precisely. A popular approach is the implied volatility concept. such as stock prices and interest rates. it is possible to extract market participants’ volatility estimations from atthemoney option prices. The relevant volatility is calculated as the standard deviation of the returns of the last 520 trading days. maturity. most liquid options have shorter maturities than convertibles. Dividend information is obtained from Primark Datastream. Unfortunately. we calculate the correlation using time series of stock price and the theoretical investment value. dividends. The most important input parameter to be estimated is the volatility of the underlying stock price. seniority) as the convertible bond are very rarely available. The investment value denotes the value of the convertible bond under the hypothetical assumption that the conversion option does not exist.
the probability values of a test for the null hypothesis of a mean overpricing of zero are presented for each convertible. The last column shows the root mean squared error of the relative mispricing. the theoretical value is above the observed market price. minimum and mean percentage overpricing of each issue. Where the issuer has straight debt in the market. the tables provide data about the maximum. Results The observed convertible bond prices on the French market are compared with theoretical prices obtained with three convertible bond pricing models. it is calculated on the basis of credit spread indices. credit analyst at UBS Warburg in London.Table 1 shows the mean credit spread expressed in basis points over the relevant period12. the Bloomberg Fair Market Curves and UBS Credit Indices. In analogy to the methodology used by Sterk (1982) and others to test option pricing formulas. 12 We thank Rupert Kenna. e. The mean percentage overpricing is presented for each convertible bond as an average of the deviation between the theoretical and observed price for each observation. Additionally. Otherwise. 13 20 . Pricing results for each individual convertible bond are graphically displayed in the appendix. i. With all three models. We obtain the largest underpricing for the component model (8.74%). It can be interpreted as a measure for the pricing fit of the model relative to market prices. for providing the daily credit spread time series. according to the characteristics of the sector in the relevant rating category.e.g. The RMSE shows the noncentral standard deviation of the relative deviations of model prices from market prices. we observe on average substantially lower market prices than theoretical prices. and Table 6. Table 5. The main results of the three implemented models are summarized13 in Table 4. A negative value indicates an underpricing. the credit spread is calculated on the basis of the traded yield spread.
For almost all convertibles. However.60%). all of which are overpriced by the model. This can be explained by the fact that the model does not account for the call feature. the binomialtree model produces the lowest theoretical price. Among those five cases. the overpricing ranges from 3. In contrast. The only exception is the LVMHconvertible. this may be caused by data outliers. The binomialtree model is closest to the market prices. The binomialtree model is the only model that in the entire sample detects cases of overpricing. where the overvaluation detected by the Margrabe model is slightly higher than that of the binomialtree model.78%. but exhibits an average underpricing of 2. sixteen convertible bonds have a mean percentage underpricing. the mean percentage deviations from market prices are significantly different from zero for 16 of the 21 convertible bonds. The significance test indicates that the mean price deviation of five of them is significantly different from zero. followed by the Margrabe and the component model. the maximum and minimum percentage overpricing for each convertible that occurred during the observation period often is very different. which have not been removed in this study. In some cases. which is present in all but one of the examined convertible bonds. representing an underpricing for each convertible bond. Prices calculated with the Margrabe model are substantially higher than both market prices and theoretical binomialtree prices. Even though the overall theoretical pricing of the binomialtree model is close to the market data.78% (Usinor 2006) to 0. Callability reduces the stockdriven upwardpotential and thus has a negative impact on convertible prices. Model prices are biased upwards because of two reasons: As in the 21 . For the component model. This underpricing prevails even though we value the convertible bond conservatively by assuming maximum dilution and setting the safety premium to zero.followed by the Margrabe model (5.47% (Vivendi 2005). the mispricing is not significantly different from zero at a five percent level.
Second. callability is neglected. The relationship between overpricing and moneyness is also positive. However. For eight convertibles in our sample. 22 . The relationship is nonlinear. This effect is of opposite direction to the omission of the call feature. The model overprices bonds that are atthemoney and outofthe money and underprices inthemoney convertibles. There seems to be a slight relationship between overpricing and maturity (see Figure 3). because it may make early conversion optimal in a world of continuously compounded dividend yields and coupon rates. These results are similar for the other models. This is of interest. Figure 2 exhibits the overpricing of the observed market prices as detected by the binomialtree model plotted against the moneyness. the more convertibles tend to be underpriced. the dividend yield is higher than the coupon rate. However. these results rely heavily on only two bonds (Axa 2014 and Axa 2017) that have a maturity far longer than the others. The longer the time to maturity. These results are similar to those obtained by Carayannopoulos (1996).Margrabe model. This finding is consistent with the above mentioned fact that the component model tends to overprice bonds with long maturities and with coupon rates below the interest rate level. the relationship between overpricing and maturity is slightly more negative for the component model. the strike price remains constant instead of growing at a rate equal to the difference between interest rate and coupon. The fact that convertibles can be converted before maturity of the bond is accounted for neither by the component model nor by the Margrabe model. This distortion is larger the longer the maturity of the bond and the lower the coupon rate is.
dilution. a model based on exchange options. Unlike the first two models. are consistent with two previous studies for the American market and anecdotal evidence from traders and other convertible bond practitioners. For all three pricing models. For all convertible bonds. the binomialtree model incorporates embedded options. the binomialtree model gives the lowest prices. 23 . A simple component model. The results of the binomialtree model are closest to the market prices while the simple component model has the greatest deviation. the underpricing is not significant for this model. underpricing is detected.Conclusion We undertake a pricing study for the French convertible bond market. and a binomialtree model are implemented. Moreover. A partition of the sample according to the moneyness indicates that the underpricing is decreasing for bonds that are further inthemoney. particularly for outofthemoney bonds. on average. Our findings of underpricing. for the majority of bonds in our sample. and credit risk. The modelgenerated prices are compared to the market prices of the investigated convertible bonds using a sample of convertible bond prices of nearly 18 months of daily data.
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TK ] yes D Is the callcondition satisfied? nt S t > Ξ t yes E Does the issuer want to call? Ωt > Kt + Θt no no continuation of the convertible bond yes F no Early redemption Does the investor want to convert? nt S t > Κ t yes conversion (forced) 26 .Figures and Tables Figure 1: Flow chart of optimal option exercise no Does the Investor want to convert? Ω t < nt ⋅ S t A yes B Are we within the conversion period? yes conversion t ∈ [τ Γ . TΓ ] no C Are we within the call period? no t ∈ [τ K .
50% 3.00% 1.50% 1.50% 0.50% Pricing points 404 397 404 150 404 90 257 404 80 377 404 404 321 234 321 404 316 464 150 404 366 27 .00% 3.00% 1.00% 2.00% 1.00% 2.50% 1.50% 3.25% 1.50% 2.75% 1.88% 1.70% 2.Table 1: Specification of the convertible bonds Exchangeable into shares of Axa Axa Axa Axa Bouygues Bull Carrefour (Promodès) France Télécom Infogrames Entertainment LVMH Peugeot PinaultPrintempsRedoute PinaultPrintempsRedoute Rhodia Scor Société Générale Total Fina Usinor Usinor Vivendi Vivendi Company Finaxa Suez Lyonnaise des Eaux Axa Axa Bouygues Bull Carrefour (Promodès) France Télécom Infogrames Entertainment Financiere Agache Peugeot Artemis PinaultPrintempsRedoute Aventis (RhônePoulenc) Scor Société Vinci Obligations Belgelec Finance Usinor Usinor Vivendi Vivendi Maturity 2007 2004 2014 2017 2006 2005 2004 2004 2005 2004 2001 2005 2003 2003 2005 2003 2004 2006 2005 2004 2005 Coupon 3.25% 1.50% 3.25% 2.00% 0.
if present). Issuing company Initial conversion ratio Finaxa Suez Lyonnaise des Eaux Axa Axa Bouygues Bull Carrefour (Promodès) France Télécom Infogrames Entertainment Financiere Agache Peugeot Artemis PinaultPrintempsRedoute Aventis (RhônePoulenc) Scor Société Vinci Obligations Belgelec Finance Usinor Usinor Vivendi Vivendi 1 1 1 1 1 1 1 10 1 1 1 10 1 1 1 1 1 1 1 1 1 Final Redemption ratio 118.63% 100. The “call trigger ratio” can refer to either the face value of the convertible or to the early redemption price (denoted as “redemption”). The “green shoe” option indicates the number of convertible bonds that could be issued on a discretionary basis.00% 130.83% 139.64% 110.Table 2: Specification of embedded options.23% 111.00% 115.93% 162.00% 115.27% no yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes yes Callability Call trigger ratio 125.00% 125.00% 130.18% 109.54% 103.00% 125.00% 112.77% 123. “Maximum number of convertibles” indicates the highest number of bonds issued according to the offering circular (including green shoe.63% 100.00% 100.00% 100.00% 100.00% 115.00% 115.00% 120.00% 130. Zero means that no green shoe was present.00% Call trigger basis redemption redemption redemption redemption redemption face value redemption face value redemption face value redemption redemption redemption redemption redemption redemption redemption redemption redemption Maximum number of convertibles 13‘037‘878 54‘655‘022 9‘239‘333 7‘643‘502 1‘905‘490 11‘491‘752 589‘471 2‘538‘543 10‘282‘744 1‘724‘137 4‘000‘000 200‘000 4‘784‘688 43‘685‘260 4‘025‘000 1‘828‘620 7‘550‘300 29‘761‘904 25‘000‘000 6‘028‘369 11‘070‘111 “Green shoe” option 0 0 1‘205‘129 996‘978 152‘440 1‘495‘752 0 250‘000 1‘341‘227 0 0 0 382‘774 0 525‘000 0 0 3‘571‘427 3‘000‘000 709‘220 1‘476‘015 28 .00% 110.00% 130.00% 250.00% 116.00% 118.00% 120.00% 130.00% 100.00% 120.00% 106.55% 100.60% 100.00% 120.00% 120.91% 100.
04% 39.09% 5.00% 0.05% 37.94% 2.75% 3.62% 1.86% 32.020 0.260 0. Télécom Infogrames LVMH Peugeot Pinault 2005 Pinault 2003 Rhodia Scor S.46% 1.00% 1.29% 45.99% 38.009 0.022 0.071 0.16% 39.89% 1.101 0. Générale Total Fina Usinor 2006 Usinor 2005 Vivendi 2004 Vivendi 2005 35.086 0.95% 39.29% 1.00% (in basis points) 45 40 73 74 84 300 42 31 300 80 40 100 80 59 26 50 50 124 119 75 82 Correlation stock/bond 0.020 0.85% 35.138 0.142 0.024 0.00% 0.071 0.18% 2.08% 66.61% 38.46% 5.208 0.Table 3: Statistics of the input parameters used Convertibles Mean of the input volatility Axa 2007 Axa 2004 Axa 2014 Axa 2017 Bouygues Bull Carrefour F.061 0.58% 46.085 0.85% 36.06% 32.19% 2.18% 2.97% 1.233 0.93% 45.016 0.37% Mean of the input Mean credit spread dividend yield 2.033 0.45% 56.58% 46.79% 5.16% 1.029 0.98% 2.12% 45.89% 35.077 29 .66% 44.29% 4.07% 39.022 0.69% 0.
64% 7.31557 0.65% 2.47% 2.67% 1.34% Mean percentage overpricing 0.99% 23.67% 5.66% 5.28% 0.18799 0.00000 0.74% 3.30344 0.37238 0.031 0.88% 3.81% 10.84% 9.00000 0.067 0.46% 1.83% 4.72% 4. Convertibles Data points Maximum percentage overpricing Axa 2007 Axa 2004 Axa 2014 Axa 2017 Bouygues Bull Carrefour F.042 0.82% 4.77267 0.019 Probability values Root mean squared error 30 .036 0.55% 21.73% 2.08% 13.68053 0.118 0.39% 5.00% 2.020 0.46% 3.60% 11.36% 9.018 0.97% 14.19% 4.78% 8.42% 7.92% 8.19% 2.17815 0.00000 0.020 0.054 0.40% 13.56% 10.037 0. “Probability values” is a two sided test for the H0 hypothesis that model prices and observed prices are equal in the mean.78% 8.Table 4: Pricing overview for the binomialtree model “Data points” indicates the number of days for which model prices are computed.142 0.86665 0.048 0.60% 3.37% 8.035 0.71% 1.58% 0.51% 11.61% 1. Télécom Infogrames LVMH Peugeot Pinault 2005 Pinault 2003 Rhodia Scor S.39% 0.51% 6.34% 9.33% Minimum percentage overpricing 5.40% 0.31523 0.040 0.00000 0.64% 17.13% 0.06953 0.23% 5.082 0.07% 1. The “root mean squared error” is the noncentral standard deviation of the relative deviations of model prices from market prices.87% 18.020 0.59718 0.72974 0.49% 0.04404 0.047 0.32% 9.11% 3.022 0.76% 2.72626 0.67% 6.089 0.40% 14.51% 3.18626 0.41% 0.017 0.83% 3.76% 16.75% 7.79780 0.78% 0. Générale Total Fina Usinor 2006 Usinor 2005 Vivendi 2004 Vivendi 2005 Mean 402 396 402 149 402 89 256 402 78 376 402 402 320 232 320 402 315 402 149 402 364 5.72% 8.62% 18.56% 3.00% 5.66270 0.
024 0.14604 0.57% 15.028 Probability values Root mean squared error 31 .09% 3.16% 0.00000 0.65% 4.15% 3.19% 9.58% 6.18% 3.133 0.72% 13.082 0.34% 21.99% 10.20149 0.87443 0.96% 6.79% 11.84% 2.04% 8.19% 15.54% 4.11% 3.05% 8.12% 9.18% 5.89% 3.10% 17.26% 14.061 0.020 0.13% 20.25% 20.00000 0.96% 19.056 0.18826 0.91% 4.66133 0.029 0.82% 2.044 0.057 0.66% 4.46% 12.22397 0.92% 3.00063 0.70% 15. Télécom Infogrames LVMH Peugeot Pinault 2005 Pinault 2003 Rhodia Scor S.25% 13.79% 7.68% 3.29% 6.37% 5.14% Minimum percentage overpricing 6.60801 0.96% 5.41% 2.62% 0.083 0.00000 0.119 0.05% 3.021 0.01% 1.00000 0.79% 1.28587 0.05% 18.038 0.04180 0.34% 4.15% 6.58% 15.31338 0.17% 0.15% 2.039 0.055 0.182 0. Générale Total Fina Usinor 2006 Usinor 2005 Vivendi 2004 Vivendi 2005 Mean 402 396 402 149 402 89 256 402 78 376 402 402 320 232 320 402 315 402 149 402 364 6.31% 2.83% 2.00000 0.029 0.83% 0.92% 6.050 0.17344 0.111 0.25% 4.57% 3.75% 6.70% Mean percentage overpricing 0.31% 7.29575 0.11763 0.00% 11.061 0.71% 13.82% 10.79% 10.24055 0.08% 7.08908 0.Table 5: Pricing overview for the Margrabe model Convertibles Data points Maximum percentage overpricing Axa 2007 Axa 2004 Axa 2014 Axa 2017 Bouygues Bull Carrefour F.47% 14.
62% 16.67% 1.58% 17.054 0.01473 0.67% 8.083 0.49% 7.43% 1.29% 15.45% 7.36% 6.93% 0.41% 4.112 0.066 0.00002 0.00000 0.00647 0.54% 7.28% 11.53% 11.69% 3.20% 14.00189 0.078 Probability values Root mean squared error 32 .049 0.52% 8.40018 0.24% 3.36% 5.99% 6.52% 13.049 0.071 0.82% 11.09978 0.107 0.131 0.00891 0.60% 24.00000 0.00000 0.213 0.51% 8.00000 0.71% 0.16% 17.66% 18.48% 17.71% 8.32% 15.056 0.058 0.094 0.09% 21.191 0.23% 6.05% 11.092 0.064 0.15% 19.40% 7.11% 8.51% 5.51% 2.25% 8.06020 0.40% 17.47% 2.72% 0.Table 6: Pricing overview for the component model Convertibles Data points Maximum percentage overpricing Axa 2007 Axa 2004 Axa 2014 Axa 2017 Bouygues Bull Carrefour F.04% 6. Générale Total Fina Usinor 2006 Usinor 2005 Vivendi 2004 Vivendi 2005 Mean 402 396 402 149 402 89 256 402 78 376 402 402 320 232 320 402 315 402 149 402 364 1.119 0. Télécom Infogrames LVMH Peugeot Pinault 2005 Pinault 2003 Rhodia Scor S.00% 6.03818 0.00000 0.89% 7.00001 0.150 0.49% 16.55% 10.70% 0.06345 0.88% 8.67% 4.03784 0.92% 12.00000 0.00009 0.061 0.97% 16.95% 1.00000 0.61% Minimum percentage overpricing 10.00% 22.43% 0.18% 8.00267 0.08% Mean percentage overpricing 5.43% 19.72% 5.66% 19.02% 14.13% 11.52% 14.120 0.40% 21.05% 10.
036 Probability values 0.036 0.66399 0.038 0.66970 0.47% 0.92101 0.92895 0.55897 0.67% 1.038 Probability values 0.67048 0. 0.95 – 1.035 0.052 0.88% 1.82% Overpricing std.34% 4.042 0.05 – 1.63% 1.20 – 2.56% 1.00% 2.20917 500 – 1000 1000 – 1500 1500 – 2500 > 2500 33 .028 0.036 0. 0.95 0.80 – 0.00 5.05 1.71704 0.19% 0.38% Overpricing std.31% 1.00 > 2.27805 0.20 1.80 0.034 0.044 0.73767 0.91594 < 500 Table 8: Pricing statistics of the binomialtree model for different maturity classes Maturity (trading days) Mean Overpricing 0.Figure 2: Moneyness/overpricing relationship for the binomialtree model Figure 3: Maturity/overpricing relationship for the binomialtree model Table 7: Pricing statistics of the binomialtree model for different moneyness classes Moneyness Mean Overpricing < 0.
20 – 2.038 0.01996 0.16% 12.040 0.024 0.00227 34 .94% 8.02% 6.95 – 1.35% 7.05 1.16323 Table 10: Pricing statistics of the component model for different maturity classes Maturity (trading days) Mean overpricing < 500 500 – 1000 1000 – 1500 1500 – 2500 > 2500 4.029 0.12380 0.04975 0.20% Overpricing std. 0.03423 0.03819 0.19% 7.040 Probability values 0.80 – 0.09094 0.80 0.Figure 4: Moneyness/overpricing relationship for the component model Figure 5: Maturity/overpricing relationship for the component model Table 9: Pricing statistics of the component model for different moneyness classes Moneyness Mean overpricing < 0.05 – 1.89% Overpricing std.05918 0.062 0.051 0.09389 0.69% 9. 0.038 0.70% 8.20 1.00 > 2.95 0.044 0.040 0.07898 0.24% 6.035 Probability values 0.00 10.03% 4.
057 0. 0.05 1.98% 2.71% 3.23156 0.67% 4.00 > 2.19% 4.80 0.05 – 1.21270 0.038 0.95 – 1.19742 35 .28808 0.045 0.34% 5.27432 0.67% 3.80 – 0.50% 1.20 1.038 0.32918 0.040 0.046 Probability values 0.027 0.13116 0.Figure 6: Moneyness/overpricing relationship for the Margrabe model Figure 7: Maturity/overpricing relationship for the Margrabe model Table 11: Pricing statistics of the Margrabe model for different moneyness classes Moneyness Mean overpricing < 0.27271 0.044 0.95% 3.87% Overpricing std.77283 Table 12: Pricing statistics of the Margrabe model for different maturity classes Maturity (trading days) Mean overpricing < 500 500 – 1000 1000 – 1500 1500 – 2500 > 2500 2. 0.00 8.036 Probability values 0.22896 0.032 0.03% Overpricing std.68% 4.56080 0.025 0.20 – 2.95 0.
08 0 50 100 150 200 250 300 350 400 trading days pricing of the Axa 2014. 3. 3% convertible 180 theoretical fair value empirical value parity investment value 0.12 150 140 130 120 110 100 0 50 100 150 200 250 300 350 400 450 trading days pricing of the Axa 2017.08 0.04 60 0.06 0.5% convertible 200 190 180 170 160 theoretical fair value empirical value parity investment value 0. 2.02 0 trading days percentage overvaluation of the Axa 2014.04 0.02 120 overvaluation 0 50 100 150 200 250 300 350 400 450 values 0 100 0.75% convertible 220 210 200 190 180 0. 0% convertible 190 180 170 160 theoretical fair value empirical value parity investment value 0.02 overvaluation 0 50 100 150 200 250 300 350 400 values 150 140 130 0 0.06 0. 0% convertible 0.04 0.14 0 50 100 150 trading days trading days 36 .08 0.06 trading days percentage overvaluation of the Axa 2004.1 0.12 0 50 100 0.04 120 110 100 0. 3% convertible 160 0.02 80 0.06 percentage overvaluation of the Axa 2007.04 140 0.06 0 50 100 150 200 250 300 350 400 450 trading days pricing of the Axa 2004.04 0.75% convertible 0.02 0. 3.04 0.02 trading days percentage overvaluation of the Axa 2017.02 0.06 0.5% convertible overvaluation 0 50 100 150 200 250 300 350 400 450 values 0.1 0.Appendix pricing of the Axa 2007. 2.06 170 160 150 140 130 120 theoretical fair value empirical value parity investment value overvaluation 150 values 0.
05 1400 1200 1000 800 600 0.08 0.15 0.1 0.12 0 50 100 150 200 250 300 trading days pricing of the France Télécom 2004.7% convertible 0.16 0.02 0.5% convertible 1300 theoretical fair value empirical value parity investment value 0.2 0.05 0 300 200 100 0.12 0. 2.2 0 50 100 150 200 250 300 350 400 450 trading days trading days 37 .09 0.1 values 1000 900 800 700 0. 1. 2. 2.02 trading days percentage overvaluation of the Carrefour 2004. 2.25% convertible 18 overvaluation 0 10 20 30 40 50 60 70 80 90 0.1 0 50 100 150 200 250 300 350 400 450 trading days pricing of the Bull 2005.1 0.06 0.7% convertible 1000 900 800 700 theoretical fair value empirical value parity investment value percentage overvaluation of the Bouygues 2006.06 0.1 0.15 overvaluation 0 50 100 150 200 250 300 350 400 450 values 600 500 400 0.pricing of the Bouygues 2006.08 0.2 0.25% convertible 20 theoretical fair value empirical value parity investment value 0.13 0. 2% convertible 2200 2000 1800 1600 theoretical fair value empirical value parity investment value 0.05 0. 2% convertible overvaluation 0 50 100 150 200 250 300 350 400 450 values 0.11 16 trading days percentage overvaluation of the Bull 2005.25 0.04 0.05 0 0.14 0.15 values 14 12 10 8 0.17 6 0 10 20 30 40 50 60 70 80 90 trading days pricing of the Carrefour 2004.25 0.15 0. 1.1 trading days percentage overvaluation of the France Télécom 2004.04 0.5% convertible 1200 1100 overvaluation 0 50 100 150 200 250 300 0 0.
09 values 2200 2000 1800 1600 1400 1200 0 50 100 150 200 250 300 350 400 450 trading days trading days 38 .07 0.08 45 0.07 0. 1.03 trading days percentage overvaluation of the LVMH 2004.06 0.11 35 0.pricing of the Infogrames Entertainment 2005.15 200 overvaluation 150 theoretical fair value empirical value parity investment value 100 0 50 100 150 200 250 300 350 400 450 0.5% convertible 50 percentage overvaluation of the Infogrames Entertainment 2005.1 values 0. 1.14 20 0.06 0. 0% convertible 500 450 overvaluation 0 50 100 150 200 250 300 350 400 values 400 0.5% convertible overvaluation 0 50 100 150 200 250 300 350 400 450 0.01 0 0.01 0. 0% convertible 550 theoretical fair value empirical value parity investment value 0 0.01 0.02 trading days percentage overvaluation of the PinaultPrintemps 2005.12 30 0.05 0 50 100 150 200 250 300 350 400 450 trading days pricing of the PinaultPrintemps 2005.04 0.1 0 50 100 150 200 250 300 350 400 trading days pricing of the Peugeot 2001.2 trading days percentage overvaluation of the Peugeot 2001. 1.05 0.08 350 300 250 0.02 0. 1.08 0.15 0 10 20 30 40 50 60 70 80 trading days pricing of the LVMH 2004.04 0.05 0 0.09 0. 2% convertible 250 0.09 200 0. 2% convertible 0.13 25 0.1 40 overvaluation theoretical fair value empirical value parity investment value 0 10 20 30 40 50 60 70 80 values 0.05 0.5% convertible 3000 2800 2600 2400 theoretical fair value empirical value parity investment value 0.03 0.5% convertible 0.
5% convertible 300 280 260 240 0.12 0.06 0.04 0. 1.04 0. 1.14 values 0 50 100 150 200 250 trading days pricing of the Scor 2005.06 values 220 200 180 160 140 120 0 50 100 150 200 250 300 350 400 450 trading days trading days 39 .04 0.01 0.06 0.08 0.03 0.04 0. 1% convertible 0.08 60 theoretical fair value empirical value parity investment value 0. 3.06 0.01 trading days percentage overvaluation of the Société Générale 2003.04 0 50 100 150 200 250 300 350 trading days pricing of the Société Générale 2003.02 0.02 240 overvaluation 0 50 100 150 200 250 300 350 values 0 220 200 180 160 140 0.1 trading days percentage overvaluation of the Scor 2005. 3.04 50 0.06 55 overvaluation 350 values 0. 1.02 25 trading days percentage overvaluation of the Rhodia 2003.08 0 50 100 150 200 250 300 350 trading days pricing of the Rhodia 2003.1 0.02 40 0 50 100 150 200 250 300 0.03 0.02 0.pricing of the PinaultPrintemps 2003. 1% convertible 65 0.02 0 0.04 0.5% convertible overvaluation theoretical fair value empirical value parity investment value 0 50 100 150 200 250 300 350 400 450 0 0.25% convertible overvaluation 20 15 0 50 100 150 200 250 0.5% convertible 0.25% convertible 30 theoretical fair value empirical value parity investment value 0.02 0 45 0.02 0.5% convertible 300 280 260 theoretical fair value empirical value parity investment value percentage overvaluation of the PinaultPrintemps 2003. 1.05 0.
1 values 16 0.04 0.04 0 50 100 150 200 250 300 350 400 450 trading days trading days 40 .875% convertible 22 values 18 overvaluation 150 0. 1.05 0 50 100 150 200 250 300 350 0 50 100 150 200 250 300 350 trading days trading days percentage overvaluation of the Usinor 2006.25% convertible 400 0.pricing of the Total Fina 2004.03 0.25% convertible 450 theoretical fair value empirical value parity investment value 0.01 overvaluation values 160 150 140 130 120 110 0 0. 1.1 12 0.04 0. 1.875% convertible 24 0.2 theoretical fair value empirical value parity investment value pricing of the Usinor 2006.11 0.15 18 overvaluation 0 50 100 150 200 250 300 350 400 450 0.01 0.12 10 0 50 100 0 50 100 150 trading days pricing of the Vivendi 2004.04 300 overvaluation 0 50 100 150 200 250 300 350 400 450 values 0.02 0.06 theoretical fair value empirical value parity investment value trading days percentage overvaluation of the Usinor 2005.5% convertible 0.03 0.02 250 0 200 0. 3% convertible 0.07 0. 1.05 0 50 100 150 200 250 300 350 400 450 trading days pricing of the Usinor 2005.05 14 12 0 10 0.5% convertible 200 190 180 170 theoretical fair value empirical value parity investment value percentage overvaluation of the Total Fina 2004.02 0.02 150 0. 3% convertible 22 20 0. 3.05 20 0.08 0.04 0.06 350 0. 3.03 0.08 trading days percentage overvaluation of the Vivendi 2004.09 16 14 0.
02 250 0 200 0.04 0 50 100 150 200 250 300 350 400 trading days trading days 41 .pricing of the Vivendi 2005.06 350 0.5% convertible 450 theoretical fair value empirical value parity investment value 0. 1. 1.02 150 0.08 percentage overvaluation of the Vivendi 2005.04 300 overvaluation 0 50 100 150 200 250 300 350 400 values 0.5% convertible 400 0.
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