Convertible Bond Prices and Inherent Biases
Posted: 17 Nov 2003
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: Suggested Citation