Option based valuation approach, Financial Management

Assignment Help:

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.


Related Discussions:- Option based valuation approach

How is present value affected by change in the discount rate, How is presen...

How is present value affected by a change in the discount rate? Present value is inversely associated to the discount rate.  In other words current value moves in the opposite

Define advantages and the disadvantages of a new stock issue, What are the ...

What are the advantages and the disadvantages of a new stock issue? A new stock issue increases funds and reduces the riskiness of the firm. It as well tends to send a negative

Define the role of cash and of earnings, Define the role of cash and of ear...

Define the role of cash and of earnings while a corporation is deciding how much, if any, cash dividends to pay to common stockholders. In the long-run earnings are essential to

Treasury bills or t-bills, Treasury bills are the bills, the governme...

Treasury bills are the bills, the government issues with maturity period of one year or less than one year. Treasury bills are usually issued as discount securiti

Preliminary screening, I am facing some problems in my assignment on the to...

I am facing some problems in my assignment on the topic Preliminary Screening. Can anybody suggest me the proper explanation for it?

Determine the amount of financing required - cost of capital, Determine the...

Determine the Amount of financing required   The last factor determining company's cost of funds is the amount of financing required, where cost of capital increases as the fin

Explain transaction exposure, How would you explain transaction exposure? H...

How would you explain transaction exposure? How is it different from economic exposure? Answer:Transaction exposure is the sensitivity of comprehend domestic currency values of

Calculate the break-even point, A Video Rental store has two employees. The...

A Video Rental store has two employees. The Supervisor is paid $2,200 per month. The other employee, Mark is paid $1,200 per month. In addition, Mark is paid a commission of 20 cen

Investment decision and financing decision, The Investment Decision: - Inv...

The Investment Decision: - Investment decision as well known as 'Capital Budgeting' is related to the selection of long-term assets or else projects in which investments will be m

Laspeyres method, Laspeyres Method Laspeyres method uses the quantities...

Laspeyres Method Laspeyres method uses the quantities consumed during the base period in computing the index number. This method is also the most commonly used method which inc

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd