Convertible Bond Question

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mmt's picture

Isn’t a convertible bond just the sum of the bond and the call option/warrant?

Then why do the notes say it is a function of the straight bond value, stock value and its warrant value. Shouldn’t it just be just straight bond value and warrant value?

pupdawg82's picture

Convertible Bond = Straight Bond + Call option on underlying stock.

It will only be converted when conv value (derived from stock price and warrant) greater than straight bond + Coupon.

Azzii's picture

where in the notes does it say that? if you follow the component approach then the value of a convertible is the value of the call option(found using that Ass scholes formula) + value of the straight bond.

im using uppermark and no where in the notes does it say that. what notes are you using if i may ask?

mmt's picture

I am using Schweser. I suspect it is because the call option is a function of the share price and that’s why they mentioned it like that.

They also mention the strategy involves selling the bond part and being left with an under-priced option. So you can strip out the bond part by hedging interest credit and interest rate risks. Why do they mention that the strategy involves hedging the firm’s equity?

mmt's picture

I think I get it. Please correct me if I am wrong.

By hedging interest rate and credit risk, you will essentially be left with the under-priced call option.

However, in order to make an arbitrage profit you will need to sell/write a similar call option at the correct price and the subsequent cash flows will net with the long call option (from the convertible bond). Thus an arbitrage profit will have been made.

But the term of the convertible bond is likely to be 15-20 years and there is no market for such long term options. Therefore instead of selling the call option you can short a portfolio (consisting of delta X stock and cash) which replicates the short call option.

So that’s why (I think) we will need to hedge the equity part by shorting delta*equity in a convertible arbitrage strategy.

Azzii's picture

this strategy that they are talking about, sounds like they are referring to the asset swap where the convertible arbitrageur retains the option to call the bond at a predetermined recall spread(price) after he has sold it to another buyer at a discount.

He will call the bond back if the price of the underlying stock rises and convertible moves into at the money position. he will then convert the bond into stock.(there are other scenarios as well where this can happen).

in short:

by shorting the underlying stock, the convertible arbitrageur hedges the equity risk
by selling the bond as a straight bond and retaining the call option, he hedges the credit risk.

schweser seems to be confusing….

Azzii's picture

your explanation makes sense, but the way you mentioned that schweser put it was confusing. Under what LO was the strategy you mentioned regarding selling a bond and being left with the undervalued call option given?

mmt's picture

I now see that part in the schweser notes. My last post was a way I thought up of trying to understand why they would want to short the stock.

Your post and the notes make more sense.

Thanks for this Azzii

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