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# capital

derivative world

32

## Pricing convertible securities

onvertible securities are traded widely in global debt markets.The most common convertible securities are convertible bonds (CBs) and convertible preferred stocks. The CB is an equity-linked instrument that gives the holder of the bond the right to convert the bond into a predetermined number of common stocks in the future. It is attractive to investors as it provides the downside protection of a straight bond with coupons and principal payback at maturity plus the upside return of equities. Being a hybrid of a bond and equity, the price behaviour of a CB is rather unique, although its pricing is not very clear-cut. In this article, I describe the features of the CB and its pricing behaviour and illustrate two common pricing methods in the market.

## Chart 1: Investment Value of Company Qs Convertible Bond

Jasvin Josen
Pricing a CB as a straight bond plus a call option on the stock

Features of a CB

Company Q issues a convertible bond with a conversion ratio of 25.32 shares. The par value of the bond is \$1000. This means that for each \$1000 of the par value of this issue that the bondholder exchanges for Company Qs stock, he will receive 25.32 shares. The stated conversion price is therefore: Par value of the CB / conversion ratio = \$1000 / 25.32 = \$39.49 If this CB pays an annual coupon of 6% with a maturity of ve years, the CB has an investment value. Assuming the risk-free discounting rate is 2.5% and the credit spread is zero, the investment value of the bond can be derived by discounting its cash ow at the risk-free discount rate, as shown in Chart 1. Now, the conversion price, realistically, is revised to: Investment value of the CB / conversion ratio = \$1162.60 / 25.32 = \$45.92 The CB example above is one of the most basic. CBs are often accompanied by a redeemable feature that allows the issuer to call back the bond after a certain period, at a predetermined price. In some cases, the issuer can only call back the bond if the price of the underlying stock is above the conversion price by a certain percentage.The callable or redeemable feature makes the CB to some extent cheaper than a non-redeemable CB.

Intuitively,a CB must be worth at least the value of a non-convertible bond of similar characteristics. If the holder does not convert, he will receive the coupons and the principal back. However, the CB is worth more than this as the holder has a chance to participate in the stock price movement. This conversion feature resembles a call option on the stock. The conversion premium increases as the spot price or the volatility of the stock increases. In Chart 3, say the current stock price is \$40. This price is not too far from the conversion price (which e ectively now is the strike price of the call option) of \$45.92.The CB holder e ectively is holding the option to buy the stock at \$45.92.As the stock price increases beyond \$40,we expect the call option to get more expensive. The call option here is priced using the Black Scholes model. The parameters are: Current stock price: \$40 Strike price: \$45.92 Risk-free rate: 2.5% Stock volatility: 20% Maturity: ve years The CB value of \$1,169.47 is then derived by adding the call option value of \$6.87 to the investment value of the bond of \$1,162.60.

## Chart 2: Convertible Bond Price Chart

Owning a CB can also be seen from another angle. The holder of the CB will only choose not to convert the CB into stock if the stock price is below the strike price of \$45.92. This is as good as saying that the owner already has the stock, but has the option to sell the stock if its price goes down beyond a certain level. In return, he gets the returns from the bond. In Chart 4, the stock value is simply the conversion value (stock price of\$40 multiplied by the conversion ratio of 25.32). The put option is arrived using the Black Scholes model,with the same parameters used to arrive at the call option on the stock in the rst pricing method. Multiplying the put option value (\$7.39) with the conversion ratio (25.32) would give us the Price behaviour of CBs put value embedded in the CB. Indirectly, this The price of the CB is a ected by movements put value represents the xed income value of in interest rates (and credit spreads) as well the convertible. as movements in the stock prices. Taking the example of Company Qs CB, there are two ex- Conclusion treme cases: There are also other more advanced pricing tech(i) When the stock price of Q is relatively small niques (but less commonly used) in the market to the conversion price of \$45.92, the CB is like multi-factor models that take into account very unlikely to be converted and, therefore, several stochastic factors that simultaneously it is e ectively a straight bond that can be a ect the price of the CB, namely interest rates, priced using the standard bond-pricing credit spreads, stock price and in some cases, method. foreign exchange rates. (ii) When the stock price is very high relative to We see that convertibles can be theoretithe conversion price, the CB will certainly cally priced using a few techniques to resembe converted into stock. The CB price will ble their real market prices. However in certain then be the conversion value, which is the situations (such as in periods of high volatility) stock price multiplied by the conversion theoretical prices can drift away away from real ratio. market prices.This is because the models used For example, if the stock price is \$60, this CB to obtain theoretical prices are subject to many is very likely to be converted. Its price will be- assumptions and are, therefore, at best, only have very much like the stock. The price of the an estimate of the real prices. The real market CB in the market is likely to be near \$1,519.20 price is determined by the random but collec(stock price of \$60 multiplied by the conversion tive behaviour of market players reacting siratio of 25.32) multaneously to interest rates, stock price and E In Chart 2, the solid line corresponds to the the issuers credit risk. conversion value,which linearly increases with the stock price.The horizontal dashed line corre- Jasvin Josen is an ex-investment banker from sponds to the price of a straight bond and is not Europe, specialising in the areas of valuation a ected by the stock price. Generally, since you and risk in financial derivatives. Currently, have the option to make the convertible bond she is back in Malaysia providing consultancy either a bond or a stock, its value should be at and training. Readers can follow her at http:// least the value of the bond or the stock. This is derivativetimes.blogspot.com/ and send their represented by the dotted line. comments to Jasvin@souqmatters.com