Valuation and Risk Analysis of Convertibles

By Jaqueline Stalder, September 12, 2003

Introduction to valuing convertibles through the Binomial Model and subsequent discussion of the feasibility of valuing convertibles through the Binomial Model.

Executive summary

In the current economic environment, convertibles take on an important role as an instrument for raising capital. The way they function is complicated, however. They generally consist of a straight bond and a conversion right that entitles the investor to convert the convertible bond into a specific number of shares. In contrast to a warrant bond, the two components of a convertible bond are inseparably linked to each other. Convertibles may be furnished with any number of additional rights and obligations covering various periods of time.

Convertibles can be divided into the straight bond component and the conversion right component, or into an equity component and a debt component. Especially in risk analysis, the bond floor is specifically examined as part of the debt component because its effect is responsible for the convexity of this instrument. The Binomial Model is employed for valuation purposes and calculates the fair value of the convertible. In addition, the factors that determine the price of the convertible are analyzed. Equity risk, credit risk, interest rate risk and option risk are examined and analyzed. Option risks are documented and graphically displayed based on sensitivities derived from the Binomial Model.

In the final section of the paper, the valuation method is applied to three different convertibles. In view of the diverse ways of structuring this financial instrument, there are limits to carrying out valuation with the Binomial Model presented in this paper. But if the contractual conditions can be suitably replicated by the model, the Binomial Model proves to be a sensible valuation instrument that is fully capable of correctly calculating the fair value of a convertible bond.