Option based valuation approach, Financial Management

When an investor purchases non-callable or non-putable convertible bonds, he would be buying a non-callable/non-putable straight security and also buying a call option on the stock, where the number of shares that can be purchased with the call option is equal to the conversion ratio. Therefore, we need to determine the fair value of the call option to determine the value of the convertible bond. The value of the convertible bond is as follows:

Value of Convertible security or bond  = Straight value + Value of the call option on the stock.

We have to add the value of the option to the straight value because the investor purchases a call option on the stock. To get the value of a convertible bond, the value of call option on the bond is to be deducted from the value of convertible security. Therefore, the value is equal to:


Value of convertible bond  = Straight value + Value of the call option on the stock - Value of the call option on the bond.

The value of the issuer's right to call depends on two factors: (i) future interest rate volatility, and (ii) economic factors that determine whether or not it is optimal for the issuer to call the security. If the callable convertible bond also has putable option, then the formula to determine the value is:


Convertible bond value =  Straight value + Value of the call option on the stock - Value of the call option on the bond + Value of the put option on the bond.

Black-Scholes option pricing model is generally used to determine the theoretical value of a call option. However, in situations where multiple options involving options that depend on future interest rates are considered, Black-Scholes method cannot be used. Researchers have suggested various models for valuation which can be classified under one-factor model or multi-factor models. But, the most common model is the one-factor model based on the price movement of the underlying common stock.

Posted Date: 9/10/2012 8:02:04 AM | Location : United States

Related Discussions:- Option based valuation approach, Assignment Help, Ask Question on Option based valuation approach, Get Answer, Expert's Help, Option based valuation approach Discussions

Write discussion on Option based valuation approach
Your posts are moderated
Related Questions
Determine in brief about Venture capitalists Venture capitalists are organisations which take on risky business ventures. They provide finance for and generally require a high

Question: The Statement of Principles for Financial Reporting sets out the principles that should underlie the preparation and presentation of general-purpose financial stateme

make an cash conversion cycle of cabbages

Q. Incorporation of the Risk in Investment Proposal? Incorporation of the Risk in Investment Proposal: - As stated previous risk is involved in every capital budgeting decision

Meaning merits nd demerits of modern approch of financial management

Constant Duration To improve a buy and hold strategy a constant average duration is imposed for the managed portfolio during the full interest rate cy

Preferably all customers will settle within the agreed terms of trade. If this doesn't happen a company needs to have in place agreed procedures for dealing with overdue accounts.

If normal operating revenues are inadequate to repay the debt, liquidation of collateral may be necessary. Corporate bonds can be either secured or unsecured by c

London Interbank Offered Rate (LIBOR) This is the base lending rate which is charged by banks in the London Eurocurrency market. LIBOR is the European equivalent of the U.S. pr