A Simple Approximation of the Value of Callable Convertible Preferred Stock

Author(s): Pradipkumar Ramanlal, Steven V. Mann and William T. Moore

Source: Financial Management, Vol. 25, No. 2 (Summer, 1996), pp. 74-85
Published by: Wiley on behalf of the Financial Management Association International
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A Simple of the
Approximation Value of
Callable Convertible Preferred Stock

PradipkumarRamanlal,Steven V. Mann,and WilliamT.Moore

Pradipkumar Ramanlal is an We develop an analyticapproximationof a model of callable convertible

Assistant Professor in the College
of Business Administration,
University of South Carolina,
Columbia, South Carolina. Steven
V Mann is an Associate Professor
in the College of Business
Administration,Universityof South
Carolina, Columbia, South
Carolina. William T. Moore is a
Professor in the College ofBusiness
Administration,Universityof South
Carolina, Columbia, South
Carolina.
preferredstock that allows for deferredcallabilityand cash dividendson
the issuingfirm'scommonstock. Predictionsof the analyticapproximation
and the numericalsolutionare close, hence we show thatthe benefit of the
method(ease of computation)outweighsthe cost (negligiblecomputational
error).Wealso showthatmodelpricespredictmarketpriceswithreasonable
accuracy.The model is developedso that it may be solved on a handheld
calculatoror on a personalcomputer,making accurateprice predictions
readily available.

0 Convertible preferred stocks represent a small but
significant source of financing. There were 128 such
issues listed on the New York Stock Exchange in
1995, with aggregate market value of over $18.5
billion. Conversion features are often added to
sweeten issues or to secure delayed equity financing.
(See Billingsley and Smith (1996) for a recent survey
and thorough analysis.) Most convertibles have call
provisions, hence conversion can be forced. Thus, the
callable convertible issue enables managers to alter
capital structure as circumstances dictate. (See Stein
(1992) for rigorous theoretical development, and
Emery, Iskander-Datta, and Rhim (1994) for an
analysis of firms' strategic use of the conversion-
forcing call.)
Reliably determining the theoretical price of a
typical convertible preferred issue, however, is not a
trivial task, despite the vintage of the relevant pricing
theory (Ingersoll, 1977) and the development of a
computational algorithm needed to apply the theory
in a realistic setting (Brennan and Schwartz, 1977,
1980). Our purpose here is to present an approximate
valuation model that takes into account all of the
material contractual features of convertible preferred
The authors are grateful for the guidance and encouragement
generously supplied by the Editors and the helpful comments from
an anonymous referee. The authorsalso express appreciationto Ms.
Ellen Roueche and Ms. RosemaryPeck for experthelp in preparation
of this manuscript, and to Mr. Ghanasyam Akella for his generous
computerprogrammingassistance.
issues (e.g., deferred callability). Our model offers
two advantages: (1) The price predictions closely
match those that arise from the exact (numerical)
solutions of the Ingersoll (1977) and Brennan and
Schwartz (1977) models, which in turn are within
1% of actual market prices on average; and (2) the
model is solved without resorting to numerical
integration.
The approximation is an adaptation of Merton's
(1974) pricing equation for consol bonds and
Ingersoll's (1977) valuation model for convertible
preferred stocks. The Ingersoll (1977) model is
expressed in terms of the gamma and incomplete
gamma functions that involve indeterminateintegrals,
the evaluation of which requiresnumerical integration
or special mathematical tables. Our model includes
an accurate polynomial approximationfor the gamma
and incomplete gamma functions, so it can be solved
with an ordinary calculator. Thus, the financial
decision maker does not have to rely exclusively on
assessments rendered by specially-trained analysts to
determine the theoretical value of a convertible
preferred issue.
The average computationalerror,i.e., the difference
between the predicted prices from the approximate
and exact models, is an eighth of a point. The median
absolute deviation between the approximateand exact
predictions is 0.8%. Moreover, the exact and
approximate models fit actual price data quite well;

Financial Management, Vol. 25, No. 2, Summer 1996, pages 74-85

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RAMANLAL,MANN& MOORE/ A SIMPLE APPROXIMATION
the mean pricing error for the exact model is about a
quarter of a point, and for the approximate model it
is about three-eighths of a point. These average errors
are on the order of the bid-ask spreads for many
NYSE-listed issues (averaging a quarter point for
common stocks and higher for preferred stocks),
suggesting that the models are at least of the quality
of most asset pricing models.
In this study, we show that the benefits of our
analytic approximation's ease of computation
outweigh the negligible cost of diminished prediction
accuracy that is introduced by using an
approximation, rather than the exact numerical
solution. For example, suppose a corporate treasurer
considers raising capital using callable convertible
preferred stock with the usual menu of contractual
features. How does the corporatetreasurerdetermine
an offering price for the issue? There are two obvious
choices: (1) Rely exclusively on an investment
banker's estimate, or (2) solve the differential
equation that underlies the valuation model via
numerical integration. Both choices have downsides.
We offer a third choice, giving corporate treasurers a
way to calculate for themselves accurate estimates for
callable convertible preferred stock values.
The article is organized as follows. In Section I,
we extend Ingersoll's (1977) model for convertible
preferredstock to allow common dividends and derive
the analytic approximation of the exact solution
allowing for call deferrals. In Section II, we compare
theoretical values predicted from the approximation
and the exact solution using parametersfrom a sample
of callable convertible preferred issues. We also
compare theoretical predictions with the actual prices
of these issues. Our conclusions are presented in
Section III.
I.An AnalyticApproximation
In Ingersoll's (1977) notation, we assume that the Constantanides and
preferred stock is convertible into a fixed proportion, Eades, 1989.) The initial condition accompanying
y, of the firm's value, V. Time to callability is denoted Equation (1) is
by r, at which point the preferred stock becomes
callable with fixed call price, K. The preferredstock's
pricing function, f(V,t), is given by the solution to
Merton's (1974) partial differential equation
1/2 o2V2fv + (rV - C)f - rf+ c = f
with two accompanying boundary conditions and an
initial condition. In Equation (1), the subscripts
denote partial derivatives, c is the standarddeviation
of the instantaneous returndV/V, r is the riskless rate,
C is the continuous cash-flow rate to all equity claims,
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75
and c is the continuous cash-flow rate to the preferred
stock. The lower-boundary condition follows from
the preferredstock's limited liability, f(0,t) = 0, while
the upper-boundarycondition arises from the optimal
exercise of the preferred stock's conversion option,
f(oo,t)
= y. (See Brennan and Schwartz 1977.)
Ingersoll (1977) shows that once the preferredstock
becomes callable, the pricing function solves the
ordinary differential equation that is obtained by
setting f equal to zero in Equation (1). His solution,
modified to permit common stock dividends, is
F( v+II[ -7] F(V)
h(V)= (2)
where [1
-()F( )]
C P(a+1l,ad)
F(V) P(a,ad) + and
--1-
r d
z
e-t ta- Idt
P(a, z) 1
F(a) j0
In Equation (2), F(a) is the gamma function, the
integral is the incomplete gamma function denoted
by F(a,z), a and d C/rV.' Just prior to
callability, the -2r/o2
preferredstock's price is given by h(V)
if it is out of the money (i.e., if V<cK/y). If the
preferred stock is in the money (i.e., if V>K/y),
preferred stockholders will exercise their conversion
option when called, and so the preferred's price
immediately prior to call equals its conversion value
yV. In addition, h(V) is greater (less) than yV if c is
greater (less) than yC. Thus, h(V) is the preferred
stock's pricing function if c > yC; if c < yC, preferred
stockholders will convert their securities into common
stock, and the preferred stock's price prior to
conversion equals its conversion value, yV (See
Grundy, 1987; and Dunn and
h(V) if V < K/y and c > yC
f (V,o) = (3)
yV if V > K/7 or c < yC
(1)
1 The two independenthomogeneous solutions satisfying (2) are V-
C/r and F(V)-C/r (see Merton, 1974). A particular solution is c/r.
The linearcombinationof these threesolutions is the generalsolution
of (1) when f is zero. The unknown coefficients in this linear
combination are determined by letting the general solution satisfy
the lower and upper boundary conditions, h(0)=0 and h(Kc/y)=yV,
respectively. This yields (2).
76 / SUMMER1996
FINANCIALMANAGEMENT

Figure 1. Convertible PreferredStock Model Values

Thehorizontal axis(V) is equityvalue($ billions).Conversion value(yV)is thelightdottedline.Line1 is thetheoreticalshare
priceforthecase in which is
callability not and
deferred, line2 the
represents case in which is
callability deferred
indefinitely.
Theexacttheoretical priceis represented by line3 andis givenby theBrennan andSchwartz (1977)algorithm. Line4 is the
approximate solutiongivenby Equation (6).
80

70

60

3
60

40
0
1
l
& 30

20

10

0 1 2 3 4 6

EquityValue(V)
To illustrate how f(V,z) evolves as the time-to- To motivate our approximation of the pricing
callability t increases, starting from the initial state function f(V,t), we examine how the initial condition,
f(V,O), we first determine the asymptotic state of f(V,O), evolves to the final state, f(V,oo), as time-to-
evolution in the limit as t approachesDoo,i.e., when callability T increases, by solving Equation (1)
the preferredstock is noncallable. The corresponding numerically, using Brennan and Schwartz's (1977)
pricing function algorithm. In Figure 1, we plot the initial condition,
the final state, and the numerical solution for deferred
g(V) = yV+ c- y)F(V) (4) callability as lines 1, 2, and 3, respectively. In Figure
1, the horizontal axis is the firm's equity value (i.e.,
is obtained by taking the limit as the call price K' the market value of common stock and all securities
approaches oC in Equation (2). The limit is readily convertible into common stock) in billions of dollars,
obtained, since F(V) is the pricing function of a consol the vertical axis is the preferredstock's price per share
bond (Merton, 1974). Accordingly, F(oo)is the present in dollars, and the straight dashed-line is the
value of a perpetuity with coupon rate C discounted conversion value (i.e., yV).2
at the riskless rate r, C/r. Again, g(V) is the preferred Examining lines 1, 2 and 3, we see that the pricing
stock's pricing function if c > yC. If c < yC, preferred function evolves in almost parallel shifts, and we can
stockholders will convert their securities into common show that the shifts are exactly parallel in the limit
stock and the preferred stock's price prior to of large V. Accordingly, we take
conversion equals its conversion value, yV. The
asymptotic solution of Equation (1) is f(V, t) = e-" f(V,0) + (1 - e-rt)f(V,oo) (6)

g(V) if c > yC
(5) 2The parametervalues used are K = 0.2522, r = 0.1040, C = 0.0984
f(Vo) and c = 0.0270, y = 0.0911, a= 0.30 and t= 5 years. The parameter
SyV if c < yC values are estimates of the Anheuser-Busch $3.60 convertible
preferredissued in Nov. 1982, callable in Nov. 1987. The cash flows
(C and c) as well as the call price (K) are in billions of dollars.

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RAMANLAL,MANN& MOORE/ A SIMPLE APPROXIMATION
as our approximation of the pricing function for call-
deferred convertible preferred stocks. Equation (6)
satisfies the lower and upper boundary conditions and
the initial condition that accompany Equation (1).
More importantly,Equation (6) satisfies Equation (1)
exactly for all values of V when z is large, and for all
values of t when V is either large or small.3 The
approximate pricing function (6) is plotted as Line 4
in Figure 1. Comparing the exact-numerical (Line 3)
and approximate-analytic (Line 4) solutions, the
analytic solution is larger(smaller) than the numerical
solution when the firm's value V is sufficiently
smaller (larger) than k/7y (V = K/y is the firm's value
at which the preferred stock is called when callable
under the perfect markets call policy).
It is clearfromEquation(6) thatthe approximationis a
weighted averageof the values of two perpetuities. As
such,the model'sapplicabilityextendsto most convertible
preferredstocks,butnot strictlyto (finite-lived)convertible
bonds. Therefore,we cautionagainstapplyingthe model
to bonds.
The pricingfunctionEquation(6) does not requirethe
intensive numericalcomputationcalled for by Brennan
and Schwartz's(1977) algorithm.Nevertheless,the initial
conditionf(V,0) and the final state f(V,oo)in Equation(6)
dependon the consol bond'spricingfunctionF(V). This
pricingfunctiondependson the ratioP(a,z) of the gamma
functions F(a,z) and F(a), which are indeterminate
integrals. To makeEquation(6) morereadilyuseable,we
provideseriesapproximations of the gammafunctions.We
accomplish this by utilizingtwo propertiesof the gamma
functions. First,F(a) and F(a,z) are boundedand slowly
varyingfunctionsof (a,z) in the domaina cEQi1,2]andz c
[0,oo). Secondly,F(a) and F(a,z) can be evaluatedoutside
this restricteddomain by using the recursive relations
F(a+l) = aF(a) and F(a+l,z) = aF(a,z) - zae-z. Series
approximationsof the gamma functionsin the restricted
domainare
F(a) = 3.11060 - 4.50364a + 3.41864a2
- 1.20456a3+ 0.17869a4 (7)
5
(-z)n
a n!(a+n) if z < 1.3
F(a,z) F(a)[0.762925 - 0.514268a + 0.341465z
+0.121829az - 0.0761437z2]
n (8)
l I(a-rm)
F(a) - m=O0 if z > 2.6
a n=0 zn
3Forlarge r, (6) converges to f(V,oo),which satisfies (1) exactly since
f is zero in that limit. For large V, f(V,O)- yV and f(V,oo)- yV + [(c/
C) -y]C/r, which may be used to verify that (6) satisfies (1) exactly.
For small V, it can be shown that (6) satisfies (1) by directsubstitution
and using the approximation F(V)- V.
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77
The series in Equation (7) and the middle series in
Equation (8) are obtained by straightforward linear
regression analysis. The R2is in excess of 0.999. The
remaining two series in Equation (8) for small and
large values of z (truncatedto 5th in z) are from Arfken
(1970, p. 472). The boundaries z = 1.3 and z = 2.6,
which determine the ranges of z for which the
different series in Equation (8) apply are determined
such that the absolute error [(fitted-exact)/exact] on
both sides of each boundary cannot be reduced by
moving it. The location of the boundaries along z
depends on the size of the parameter a (z = 1.3 and
2.6 when a = 1.5).
In Figure 2, we depict the percentage error in the
incomplete gamma function ratio P(a, z) = F(a, z)/
F(a) for values of a E[1, 2] and values of z E[0, 7].
The maximum error is less than 1.5%, and is
negligible for most values of (a, z).
II.Tests of the Model
A. The Sample
The initial sample includes all convertible preferred
stocks listed on the New York Stock Exchange
(NYSE) at any time during 1982-1988. The choice
of this intermediate window allows us to examine
preferred issues with long price histories (between
1968 and 1994) while keeping the data collection
effort manageable.We take preferredstock prices from
the NYSE Daily Stock Price Record. Of the three
stock markets, the NYSE, AMEX, and NASDAQ, the
NYSE lists over 94 % of the dollarvalue of convertible
preferreds.4 Most utilities have more than one
convertible issue, or warrants outstanding. This
inhibits the analysis, due to the need to record prices
of all equity claims on a given firm. Restricting the
sample to non-utilities yields 236 issues.
The main source of sample information, apart from
the NYSE Daily Stock Price Record, is Moody 's
Industrial Manual. There are 135 firms with
sufficient information in Moody's to determine the
precise call and conversion terms. Of these, 41 have
other contingent equity claims outstanding that are
not listed on the NYSE, making it difficult (for
researcherswho have access only to publicly available
data) to estimate firm value accurately. Sixty-three
firms have insufficient trading frequency (at least 30
return observations per quarter) to estimate return
variances. When we remove issues that are
exchangeable for securities other than common stock
or that feature adjustable dividend rates, we have a
4 Source: NYSEDaily StockPrice Record,AMEXDaily StockPrice
Record, and the Over the CounterDaily StockPrice Record, various
issues, 1982-88.
78 FINANCIALMANAGEMENT
/ SUMMER1996

Figure 2. Errorsin the Approximationof the Incomplete Gamma Function Ratio P (a,z) = F (a,z)/F(a)
Theapproximation forF(a)is fromEquation (7) andtheapproximationforF (a,z)is fromEquation (8).Thevaluesof theparameter
a rangefromI to 2, andz is plottedfrom0 to 7. Thepercentage
erroris theheightof thesurface,determinedas(approximateP(a,z)-
exactP(a,z))/ exactP(a,z).

..
Si
S i ................
... ..
.... .........
. ..
2.0
• .......
.. ." i ..j ..
............................,.................
.....
, y..... ................ 10.5
..... .
.
...........
1... .O .
............
...... .... ..... ...
... •. Erro r ( %)
... • . ....... 0 .5
!,'
............... .....
1 .8.. ......2.. .....

-..........--...............0........r
1.8 2I ,
1.2

a 1 .6 1.. 0
1.0 :2.0 ..........
0,
........... ........
a 3

sample of 24 preferred stock issues. Price data are equity value of firms with outstanding convertible
collected from the date of issue to when the issue was preferredswas $1.634 billion, hence our sample firms
called, delisted, or 1994 (for those that remained are roughly comparable in size. The mean ratio of
outstanding), yielding a total of 27,544 observations. preferred to common value on the NYSE is 0.132,
We note that the majority (over 100) of the lost not significantly different from the sample mean ratio
observations are due to nonavailability of information of 0.154 (t-statistic = 0.51 for test of difference in
on call profiles and conversion terms in a convenient means).
format, i.e., Moody s. The details about call and
conversion features should be available to the B. Model Estimation
financial decision maker, therefore the relatively The benchmark model is the exact numerical
modest sample size (in terms of number of issues) solution of the differential Equation (1), with
does not suggest limited applicability of the model. boundary and initial conditions that accurately
The sample convertible preferred issues are capture the preferred stock contract provisions.
described in Table 1. The market values of common Specifically, we allow for contractual call delays and
and preferred in Table 1 are determined based on the a time-varying call price once callable. Time
prices observed immediately following the issue of variation in call price occurs due to the accrual of
the preferreds. The mean values of the preferredand dividends and contractually stipulated changes in the
the common at the time of issuance are $141.89 nominal call price; both features are accommodated.
million and $1.016 billion, respectively. The mean We also allow for non-zero common stock dividends,
ratio of the value of the preferred issue to common in contrast to Ingersoll (1977), but we hold common
equity at that time is 0.207, thus the issues represent and preferred dividend rates constant, in contrast to
significant components of capital structure. Emanuel (1983).
To see if our sample is representative, we compare Equation (1) is solved by using the finite difference
the market values of the preferred and the common method (Brennan and Schwartz, 1977). We account
in our entire sample to that of the population at the for periodic cash flows to the common stock and/or
middle of our sample period (1985). The average preferred stock and time-varying conversions ratios
common equity value of the sample at that time was and/or call prices by changing boundaryand/or initial
$1.585 billion. On the NYSE, the average common conditions. Our approximation of the exact solution

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 MANN&MOORE/ A SIMPLEAPPROXIMATION
RAMANLAL, 79

Table1. SampleDescription
This table identifiesthe convertiblepreferredissues. It includesdates of issuance,marketvalues of common stock and preferred
stock at issuance,anddateswhen the issues firstbecamecallable. Thereare24 issues, all of which were listed on the NYSE during
the 1980s.
MarketValue MarketValue
Issue/Series/ Issue Common Stock Convertible First Date
Dividend Date (million) PreferredStock Callable
(million)
Allegheny Intl. $11.25 Jan. 1982 $ 286.90 $239.70 Jan. 1985
Allied Corp Series C $6.74 July 1981 2,325.00 215.90 Aug. 1986
Allied Corp Series D $12.00 Oct. 1981 2,325.00 145.40 Oct. 1986
Anheuser-Busch $3.60 Nov. 1982 5,260.00 578.40 Nov. 1987
Arvin Ind. $2.00 Apr. 1976 110.80 21.36 Apr. 1978
Assoc. Dry Goods SeriesA $4.75 May 1981 868.60 255.90 May 1986
Bell & Howell SeriesA $.60 Nov. 1983 230.10 110.50 Jan. 1998
Castle& Cooke $.90 July 1985 1,076.00 272.80 Sept. 1988
Chromalloy$5.00 June1968 245.10 90.24 Aug. 1972
CluettPeabody $1.00 Aug. 1968 282.30 29.63 Oct. 1973
B. F. GoodrichSeriesA $3.50 Nov. 1986 1,228.00 116.70 Jan. 1990
Ingersoll-Rand $2.35 Jan. 1969 986.10 125.80 Jan. 1974
Koppers $10.00 Dec. 1980 537.20 60.70 Dec. 1983
Lafarge $2.44 Nov. 1983 345.60 28.65 Anytime
Libbey Owens FordSeriesA $4.75 Sept. 1968 401.50 79.12 Jan. 1974
MarkControlsSeries A $1.20 Oct. 1977 47.32 18.71 Oct. 1981
Moore-McCormack $10.00 Dec. 1983 200.70 34.36 Dec. 1986
Munford,Inc. 4% Nov. 1968 23.94 6.82 Dec. 1973
Savin SeriesA $1.50 Dec. 1979 86.03 8.93 Anytime
Sun Co. $2.25 Oct. 1968 2,994.00 406.80 Anytime
Time, Inc. Series B $1.575 Nov. 1978 1,475.00 257.60 July 1986
Time, Inc. Series C $4.50 Jan. 1981 1,800.00 181.40 Anytime
U.S. Gypsum $1.80 Dec. 1967 447.00 47.81 Jan. 1974
F. W.WoolworthSeries A $2.20 Mar. 1969 776.90 Jan. 1976
72.15

is given by Equation (6), where F(a) and F(a, z) are Stock Price Record.
determined from Equations (7) and (8), respectively.5
The basic program for this approximation is provided C = Total annual dividends on common and
in the appendix. convertible preferred stock from
Thus we test two models: (a) The exact pricing Moody 'sIndustrial Manuals. The most
model, using the numerical technique of Brennan and recent size and periodicity of dividends
Schwartz (1977), and (b) the approximation Equation is assumed to persist in determining C.
(6) using approximate values of F(a) and F(a, z). We
refer to these models henceforth as EXACT and c = Totalannualdividendson the convertible
APPROX, respectively. preferredissue to be valued.
The parameters used for calculating prices for all
three models are: cK(t) = Aggregate call price plus accrued
dividends at time r from Moody's
V(T) = Market value at time T of the firm's Industrial Manuals. For the exact
equity securities; i.e., common stock model, we use the entire call profile.
plus all convertible preferred issues. For the approximate models, we use
These data are from the NYSE Daily only the call price in force when first
5Wehavealsoanalyzed(6) butwithF(a)andF(a,z) calculatedusing
callable.
a complex and accuratemethod involving continuedfractions
availableon the softwareMathematica.Thismethodas opposedto = Conversion ratio at time t, i.e., the
evaluatingtheintegralsnumericallyhastheadvantageof providing y('t)
fraction of aggregate equity value that
accuracy to the desired precision because of its convergence
properties.Pricingerrorsusing(7) and(8) insteadarenegligible. would be held by the convertible

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80 FINANCIALMANAGEMENT
/ SUMMER1996

Table2. Deviationsbetween Exactand ApproximateModels

Thistablecontainssummary statisticsfordeviations
of pricepredictions
basedontheapproximatemodel(PRICE APPROX)from
basedon theexactsolution(PRICE
pricepredictions EXACT)appliedto 27,544observations
for24 convertible issues.
preferrred
1. Mean ( median) deviation -$0.1662
(PRICEAPPROX- PRICEEXACT) (-$0.1307)
2. Mean (median) percentage deviation -0.5771%
(PRICE -
APPROX PRICEEXACT)/PRICEEXACT) (-0.3982%)
3. Mean (median) absolute deviation $0.5995
($0.2959)
4. Mean (median) absolute 1.2500%
percentage deviation
(0.7997%)
(0.7997%)

preferredstockholdersupon conversion (median) deviation of APPROX from EXACT is

of the issue. These data are from
Moody's Industrial Manuals.
2 = Varianceof the instantaneous returnon
equity, dV/V, estimated from sample
variance of ln(Vt/Vt-1),using all daily
data from the quarter preceding the
month in which the preferred stock
value is calculated.
r = Rate on a 30-year zero-coupon Treasury
bond in force at the time the preferred
stock value is calculated; published by
Coleman, Fisher, and Ibbotson (1989).
C. ModelAccuracy
We first compare the approximation with the exact
numerical solution obtained by the method that
Brennan and Schwartz (1977) prescribe, i.e., we
compare APPROX with EXACT. Then we observe
how well both APPROX and EXACT fit actual market
prices. Finally, we analyze pricing errors for
significant biases in the approximate model's
prediction of market prices.
1. Comparison of APPROXwith EXACT
Dollar deviations of price predictions of APPROX
from EXACT are defined as
-$.1662 (-$.1307), well under a quarter point. The
mean (median) percentage deviation is -0.5771
(-0.3982)%. The mean and median absolute
deviations, $0.5995 and $0.2959, respectively, are
also small.
Most of the deviations of APPROX from EXACT
are within +5 %, as shown in Figure 3, Panel A. The
distribution is decidedly peaked, with the majority of
deviations near zero. Thus, we judge the
approximation to be reliable.
2. Comparison of Modelwith Market
We now determine how well the models (EXACT
and APPROX) fit actual market prices. We define
the dollar pricing errors from the exact numerical
solution (EXACT) and from the approximate model
(APPROX), respectively, as
-
PRICEEXACT PRICEMARKET
andPRICE APPROX- PRICEMARKET (12)
where PRICEMARKET = NYSE closing price of the
preferred issue.
We define the percentage pricing errors as

PRICEAPPROX- PRICEEXACT(9) (PRICEEXACT-PRICEMARKET)/PRICEMARKET(13)

and

Percentage deviations are defined as - PRICEMARKET)/PRICEMARKET

- PRICEEXACT)/PRICEEXACT (10)
(PRICEAPPROX
Results of analysis of these deviations for the 27,544
observations are presented in Table 2. The mean
(PRICEAPPROX (14)
Analysis of the errors is presented in Table 3. The
mean (median) dollar pricing error for EXACT is
-$0.2360 (-$0.09), about one-quarter (one-eighth) of
a point. The mean (median) error for APPROX is
-$0.4021 (-$0.2064), aboutthree-eighths(one-quarter)of
a point. Thus, on average, the exact model fits the

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 MANN&MOORE/ A SIMPLEAPPROXIMATION
RAMANLAL, 81

Figure3. FrequencyHistogramsfor PercentageDeviationsof Approximate

fromExactModel(Panel
A), ExactModelPredictionsfromMarket Price(PanelB), and ApproximateModelPredictionsfrom
MarketPrices(PanelC)

A. Percentage Deviation of APPROXfrom EXACT

6000

4500

3000

1500

-0.250 -0.167 -0.083 0.000 0.083 0.167 0.250

B. Percentage Pricing Error of EXACT

6000

4500

3000

1500

-0.250 -0.167 -0.083 0.000 0.083 0.167 0.250

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82 FINANCIALMANAGEMENT
/ SUMMER1996

C. Percentage Pricing Error of APPROX

6000

4500

3000

1500

0
-0.250
l.i1i3111
-0.167 -0.083 0.000
Ii0.083 I

0.167 0.250

Table 3. Analysis of Pricing Errors

Thetablereportsmeanandmedianvaluesforpricingerrorsfortwoprediction models,as appliedto convertible stocks.
preferred
Errorsaremeasuredrelativeto marketprices.TheEXACTmodelis thenumerical solutionof Merton's(1974)partialdifferential
equation,andtheAPPROXmodelis fromEquation (6) withF(a)andF(a,z)takenfromEquations (7) and(8), respectively.

EXACT APPROX

1. Mean (median) -$0.2360 -$0.4021

pricing error ($0.0900) (-$0.2064)
2. Mean (median) -0.3594% -0.9197%
percentage pricing error (0.2416%) (-0.6196)
3. Mean (median) absolute $2.1331 $2.2632
pricing error ($1.2000) ($1.1902)
4. Mean (median) absolute 5.05% 5.29%
percentage pricing error (3.27%) (3.27%)
data with better accuracy than the bid-ask spread, information relative to the exact solution of the
while the approximate model does at least as well as differential equation.
the spread. The mean and median errors introduced
3. Bias Analysis
by using APPROX instead of EXACT is about an
additional one-eighth of a point. Mean percentage We analyze the pricing errors of APPROX relative
pricing errors are -0.3594% for EXACT and to MARKET to determine whether there are
-0.9197% for APPROX. While the APPROX errors significant biases according to (1) volatility (02); (2)
are about three times those of EXACT, we judge both the time to which the call provision is activated (t);
to be economically insignificant. and (3) the degree to which the issue is "in the
The absolute pricing errors given in Table 3 for money", i.e., the ratio of conversion value to call
both models are not trivial, but it is clear that price.6 We denote these variables as VAR, TIME,
APPROX does almost as well in capturing actual and MONEY, respectively, and we estimate
prices as EXACT. The empirical distributions of the parametersof the regression of the percentage pricing
percentage pricing errors from EXACT and APPROX error from APPROX on these three variables. We
are shown in Panels B and C of Figure 3. The shape,
dispersion, and location of each distribution are 6 We only provide a bias
analysis of pricing errors of APPROX
almost indistinguishable, hence, using the relative to MARKET because it is the APPROX model, we contend,
approximation results in only a small loss in that will be of most practical use.

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RAMANLAL,MANN& MOORE/ A SIMPLE APPROXIMATION 83

Table4. Bias Analysisof PricingErrors

Thefollowingmodelis estimated by ordinary leastsquares: +3 VAR+P2 TIME+ 33MONEY+ E,
%ERR=3p0
where%ERR= percentage pricingerrorof APPROXmodel,fromEquation (6);VAR= estimatedvarianceof returnon equity;
TIME= timeremaining untilissueis callable(inyears);andMONEY= ratioof conversion
valueto callprice.

CoefficientEstimates t-Statistic R2

Po -0.0143 -13.67*** 0.0046

P,(VAR) -0.0233 -5.50***

P2(TIME) -0.0001 -0.43

P3 (MONEY) 0.0094 9.47***

at the 0.01 level.

***Significant

report our results in Table 4. No significant bias due
to time to callability (TIME) is evident (t = -0.43).
However, we do see a statistically significant negative
volatility bias, and a significant positive bias
attributableto the degree the issue is in the money(VAR:
t-statistic = -5.50; MONEY: t-statistic = 9.47). The
economic significanceof these biases,however,is trivial.
The coefficientestimateof -0.02326 for VAR meansthat
an increasein a from, say, 0.4 to 0.5 (hence 02 from
0.0016 to 0.0025), induces a downwardeffect of about
0.002 percent on the pricing error. An increase in
MONEY from, say, 1.2 to 1.3, produces an upward
effect of about 0.09 percent on the error.
Ill.Conclusion
Following the pioneering efforts by Merton (1974),
Ingersoll (1977), and Brennan and Schwartz (1977),
we have developed an analytic approximation for the
value of a callable convertible preferred stock. The
approximation is not an ad hoc development; it is
derived rigorously, has a natural interpretation, and
holds exactly within the relevant limits. Moreover,
it is more general than the analytic models of Ingersoll
(1977), as it allows for common stock dividends and
deferred callability. The theoretical values obtained
from the approximation are highly correlated with
those from the exact solution of the Merton (1974)
partial differential equation, and the exact and
approximatemodels fit actual prices well.
As far as we are aware, this is the first effort to
develop an easy-to-use model of callable convertible
security values that allows for realistic contract
features and cash flow assumptions. Ingersoll's
(1977) solution for callable nonconvertible preferred
stock has been tested on market data by Ferreira,
Spivey, and Edwards (1992). Their pricing errors
appearto be largerthan those we find for convertibles,
possibly due to our explicit treatment of deferred
callability. Our model is based on perfect markets
assumptions, hence some improvement is possible by
allowing for taxes (see Mauer, Barnea, and Kim,
1991). In addition, allowance for interest rate
uncertainty might improve accuracy, although it
would be a daunting task to reduce such a model to a
useful approximation. 0

References
Arfken, G., 1970, Mathematical Methodsfor Physicists, New York, Brennan,M. andE. Schwartz,1980,"AnalyzingConvertibleBonds,"Jour-
NY, Academic Press. nal ofFinancialandQuantitativeAnalysis(November),907-929.

Billingsley, R. S. and D. M. Smith, 1996, "WhyDo Firms Issue Con-
vertible Debt?," Financial Management (Summer), 93-99.
Brennan, M. and E. Schwartz, 1977, "Convertible Bonds: Valua-
tion and Optimal Strategies for Call and Conversion,"Jour-
nal of Finance (December), 1699-1715.
Coleman, T., L. Fisher, and R. Ibbotson, 1989, U.S. Treasury Yield
Curves 1926-1988, New York, NY, Moody's Investors
Service, Inc.
Constantinides, G. and B. Grundy, 1987, "Call and Conversion of
Corporate Bonds: Theory and Evidence," University of
Chicago working paper.

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All use subject to JSTOR Terms and Conditions
84 FINANCIALMANAGEMENT
/ SUMMER1996

Dunn, K.B. and K.M. Eades, 1989, "Voluntary Conversion of Ingersoll, J., 1977, "A Contingent-ClaimsValuationof Convertible
Convertible Securities and the Optimal Call Strategy," Securities," Journal of Financial Economics (May), 289-
Journal of Financial Economics (August), 273-302. 321.

Emanuel, D., 1983, "A Theoretical Model for Valuing Preferred
Stock," Journal of Finance (September), 1133-1155.
Emery, D.R., M.E. Iskander-Datta, and J. Rhim, 1994, "Capital
StructureManagementas a Motivationfor Calling Convertible
Debt,"Journal of Financial Research (Spring), 91-104.
Mauer, D.C., A. Barnea, and C. Kim, 1991, "Valuationof Callable
Bonds under Progressive Personal Taxes and Interest Rate
Uncertainty," Financial Management (Summer), 50-59.
Merton,R., 1974,"Onthe Pricingof CorporateDebt: The Risk Structure
of InterestRates,"JournalofFinance (May), 449-470.

Ferreira,E. J., M. F. Spivey, and C. E. Edwards, 1992, "PricingNew- Stein, J. C., 1992, "ConvertibleBondsas BackdoorEquityFinancing,"
issueandSeasonedPreferredStocks: A Comparisonof Valuation Journal of Financial Economics (August), 3-21.
Models," Financial Management(Summer),52-62.

Appendix:Basic ComputerProgramfor ConvertiblePreferredStock Valuation

The program solves the approximate valuation model given in Equation (6). After the program has been
loaded, press [F2] to run. At this point you will be prompted with a series of questions beginning with
"Riskless rate (r):" and ending with "Equity Value (E)."

Example: 120 DEFSNG G,C,A,S,B,F

160 DEF FNPOWER! (PB!,PX!)= EXP (PX*
Riskless rate (r): 0.104 LOG(PB))
Standard deviation (sigma): 0.2522 165 DEF FNGAMMA! (GA!)=3.1106- (4.50364*
Total annual cash flow on all equity claims (C): GA)+(3.41864*FNPOWER(GA,2))-(1.20456*
98400000 FNPOWER(GA,3))+(. 17869*FNPOWER(GA,4))
Total annual cash flow on preferred stock (c): 166 DEF FNPFUNCTION!(PGIA!)=
27000000 GAMMAINCOMP/FNGAMMA(PGIA)
Conversion factor (alpha): 0.0911 170 GOTO 870
Aggregate call price (K): 300000000 190 FACT =1
Time to convertibility (t) in years: 5 200 WHILE (DFACTORIALV>1)
Number of preferred shares: 7500000 210 FACT = FACT*DFACTORIALV
Equity value (E): 2500000000 220 DFACTORIALV= DFACTORIALV-1
230 WEND
Value of the callable convertible security = 43.79425 240 RETURN
270 GOTO 870
After running the example, you can run another by 290 11 = 5
pressing [F2], or exit the program. 300 SIGMA = 0
310 BETA = 1
10 INPUT "Riskless rate (r): ", R! 320 IF GIZ >=1.3 THEN GOTO 401
20 INPUT "Standarddeviation (sigma): ", N! 330 FOR 11=5 TO 0 STEP -1
30 INPUT "Total annual cash flow on all equity 340 GIEXP = II
claims (C): ", E! 345 DCHECK = II
40 INPUT "Total annual cash flow on preferred 350 DFACTORIALV= II
stock (c): ", C! 360 GOSUB 190
50 INPUT "Conversion factor (alpha): ", M! 365 GOSUB 392
60 INPUT "Aggregate call price (K): ", K! 370 NEXT
70 INPUT "Time to convertibility (t) in years: ", 380 GAMMAINCOMP = FNPOWER (GIZ,GIA)*
T! SIGMA
75 INPUT "Number of preferred shares: ", NO! 385 RETURN
80 INPUT "Equity value (E): ", V! 391 GOTO 870
110 DEFINT I 392 ICHECK = (11-((11\2)*2))

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RAMANLAL,MANN& MOOREI A SIMPLE APPROXIMATION 85

393 IF ICHECK = 1 THEN SIGMA = SIGMA- 692 PA = FNPFUNCTION(GIA)

(FNPOWER(GIZ,GIEXP)/(FACT*(GIA+GIEXP))) 693 GIA = GIA+1
ELSE SIGMA = SIGMA+(FNPOWER(GIZ, 694 GOSUB 290
GIEXP)/(FACT*(GIA+GIEXP))) 695 PAl = FNPFUNCTION (GIA)
399 RETURN 696 FFUNCTION = E*(1-PA+((GIA-1)*PA1/GIZ))/
401 IF GIZ <=2.6 THEN GOTO 500 R
410 FOR I1 = 5 TO OSTEP -1 698 RETURN
420 GIEXP = I1 699 GOTO 870
430 FOR I2 = I1 TO 0 STEP -1 700 FV = V
440 BETA = BETA*(GIA-I2) 710 GOSUB 620
450 NEXT I2 720 ASYMPTOTIC = (M*V)+((C/E)-M)*
460 SIGMA = SIGMA+(BETA/FNPOWER(GIZ, FFUNCTION
GIEXP)) 725 ASYMPTOTICM = ASYMPTOTIC
470 NEXT I1 730 RETURN
480 GAMMAINCOMP = FNGAMMA(GIA)- 760 GOTO 870
((FNPOWER(GIZ,GIA-1)*EXP(-GIZ)/GIA)* 770 GOSUB 680
SIGMA) 780 CALLNUM1 = (M-(C/E)*(M/K)*
490 RETURN FFUNCTION)*V
500 GAMMAINCOMP = 790 CALLDENOM = (1-(M/K)*FFUNCTION)
FNGAMMA(GIA)*(.762925- 800 FV = V
(.514268*GIA)+(.341465*GIZ)+(.121829* 810 GOSUB 620
GIA*GIZ)-(.0761437*FNPOWER(GIZ,2))) 820 CALLNUM2 = ((C/E)-M)*FFUNCTION
510 RETURN 830 CALLABLE = (CALLNUM1 + CALLNUM2)/
609 GOTO 870 CALLDENOM
620 GIA = 2*R/FNPOWER(N,2) 835 CALLABLEM = CALLABLE
630 GIZ = 2*E/((FV)*(FNPOWER(N,2))) 840 RETURN
640 GOSUB 290 870 IF (V<(K/M)) AND (C>(M*E)) THEN GOSUB
641 PA = FNPFUNCTION (GIA) 770 ELSE CALLABLEM = M*V
642 GIA = GIA +1 910 IF (C>(M*E)) THEN GOSUB 700 ELSE
643 GOSUB 290 ASYMPTOTICM = M*V
644 PAl = FNPFUNCTION(GIA) 950 CALLCONVERTBOND = (EXP(-R*T)*
650 FFUNCTION = E*(1-PA+((GIA-1)*PA1/GIZ))/ CALLABLEM)+ ((1-EXP(-
R R*T))*ASYMPTOTICM)
660 RETURN 955 PREFVAL = CALLCONVERTBOND/NO!
670 GOTO 870 956 PRINT
680 GIA = 2*R/(FNPOWER(N,2)) 957 PRINT
690 GIZ = 2*E*M/ (K*FNPOWER(N,2)) 960 PRINT "Value of the callable convertible
691 GOSUB 290 security = " PREFVAL

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