Convertible Bond Prices and Inherent Biases

Posted: 17 Nov 2003

See all articles by Peter Carayannopoulos

Peter Carayannopoulos

Wilfrid Laurier University - School of Business & Economics

Madhu Kalimipalli

Lazaridis School of Business and Economics, Wilfrid Laurier University

Abstract

The paper examines the pricing performance of a convertible bond valuation model developed within the Duffie and Singleton (1999) reduced-form credit risk valuation framework. A recent sample of monthly U.S. convertible bond prices observed during the period from January 2001 to September 2002 is used. To our knowledge this is the only recent study to have used recent U.S. data and as such it enhances greatly our understanding of the particular market. We find that the model produces prices that are consistently lower than observed market prices when the embedded conversion option is in-the-money and higher than observed market prices when the conversion option is out-of-the-money. While at least part of the in-the-money bias can be attributed to the firm's optimal call policy assumed by the theoretical model, the out-of-the-money bias is more difficult to explain. Evidence from our sample suggests that the deep out-of-the-money bias is not related to the theoretical model's performance. Instead the bias is the result of the fact that convertible bonds with low conversion value seem to be generally underpriced to the extent that their prices often imply negative embedded option values.

JEL Classification: G10, G13

Suggested Citation

Carayannopoulos, Peter and Kalimipalli, Madhu, Convertible Bond Prices and Inherent Biases. Journal of Fixed Income, Forthcoming. Available at SSRN: https://ssrn.com/abstract=461081

Peter Carayannopoulos

Wilfrid Laurier University - School of Business & Economics ( email )

80-University Avenue west
Waterloo, Ontario N2L 3C5
Canada

Madhu Kalimipalli (Contact Author)

Lazaridis School of Business and Economics, Wilfrid Laurier University ( email )

Waterloo, Ontario N2L 3C5
Canada
519-884-0710 (Phone)

HOME PAGE: http://www.madhukalimipalli.com/

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