Intrinsic value of convertibles The intrinsic value of a convertible bond is the greater of 1. Conversion value 2. Bond investment value-value as a corporate bond without the conversion option(based on the convertible bonds cash flow if not converted) To estimate the bond investment value. one has to determine the required yield on a non-convertible bond with the same quality rating and similar investment characteristics If the convertible bond does not sell for the greater of these two values, arbitrage profits could be realized 16
16 Intrinsic value of convertibles The intrinsic value of a convertible bond is the greater of 1. Conversion value 2. Bond investment value – value as a corporate bond without the conversion option (based on the convertible bond’s cash flow if not converted). • To estimate the bond investment value, one has to determine the required yield on a non-convertible bond with the same quality rating and similar investment characteristics. • If the convertible bond does not sell for the greater of these two values, arbitrage profits could be realized
Convertible= bond warrant Factors that affect the bond component Interest rates Credit rating/spreads Coupon Duration Factors that affect the warrant component Stock performance Embedded strike price Common dividend yield and dividend growth rate Stock volatility Life of warrant/ call protection
17 Convertible = bond + warrant Factors that affect the bond component • Interest rates • Credit rating/spreads • Coupon • Duration Factors that affect the warrant component Stock performance • Embedded strike price • Common dividend yield and dividend growth rate • Stock volatility • Life of warrant / call protection
Put plus stock plus yield advantage Applying the put-call parity call bond= put stock Here, put is the right to sell the stock for bond Dne may treat a convertible bond as yield-enhanced stock Op lus a put option he put option represents the bond floor protection The strike price is the bond investment value
18 Put plus stock plus yield advantage Applying the put-call parity: call + bond = put + stock. Here, put is the right to sell the stock for bond One may treat a convertible bond as yield-enhanced stock plus a put option. • The put option represents the bond floor protection. The strike price is the bond investment value
Bond investment value Present value of the interest and principal payments discounted at the straight(non-convertible) bond interest rate P bond interest value 1=1(1+r )(1+r) where P= par value, r= discount rate, C=couponrate n= number of periods to maturity. resent present pi value value Years payment factor -20 $80 8.514 $681.12 20 $1,0000.149 $14900 830.1 take r=10%
19 Bond investment value • Present value of the interest and principal payments discounted at the straight (non-convertible) bond interest rate bond interest value = where P = par value, r = discount rate, C = coupon rate, n = number of periods to maturity. take r = 10% present present value value Years payment factor 1 - 20 $80 8.514 $681.12 20 $1,000 0.149 $149.00 $830.12 n n t t r P r C (1 ) (1 ) 1 + + + =
Estimation of the discount rate Use the yield-to-maturity of a similar non- convertible bond as a proxy The apparent deterioration of the creditworthiness of an issue will not be reflected in the convertible price because the common stock may be rising due to higher share price volatility
20 Estimation of the discount rate Use the yield-to-maturity of a similar nonconvertible bond as a proxy. • The apparent deterioration of the creditworthiness of an issue will not be reflected in the convertible price because the common stock may be rising due to higher share price volatility