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

What theoretical share price share for share exchange, What theoretical sha...

What theoretical share price share for share exchange Establish what theoretical share price may be after the merger in a share for share exchange incorporating the effects of

Capital budgeting assignment, Assignment 2 Decision Tree Assessing Alterna...

Assignment 2 Decision Tree Assessing Alternatives in Capital Budgeting [see Bailes, J.C., and Nielsen, J.F. (2001, Winter). Using decision trees to manage capital budgets. Manag

Concept of yield spreads, The Central Bank is an authority responsible for ...

The Central Bank is an authority responsible for monetary policy of its country. It regulates money supply and credit, issues currency, and manages exchange rate.

Common-size statement value, A firm has sales of $6,500, net income of $500...

A firm has sales of $6,500, net income of $500, total assets of $12,000, and total equity of $700. Interest expense is $1000. What will be the common-size statement value of the in

Explain the determinants of operating exposure, Explain the determinants of...

Explain the determinants of operating exposure. Answer:  The main determinants of a company’s operating exposure are (a) The structure of the markets where the company sourc

Expalin depository institutions, Depository institutions Depository ins...

Depository institutions Depository institutions: intermediaries with a important proportion of their funds derived from customer deposits - include commercial banks - savings i

Equity share valuation.., Mount Hutt Ltd. just paid dividend of $2.20 per s...

Mount Hutt Ltd. just paid dividend of $2.20 per share. The dividends are expected to grow at a constant rate of 4% per year, indefinitely. If investors require an 11% return on Mou

What can financial institution do for deficit economic unit, What can a fin...

What can a financial institution Frequently do for a deficit economic unit (DEU) that it would have difficulty doing for itself if the DEU were to deal directly along with an SEU?

Ratio calculations from financial statements, Ricardo Martinez has prepared...

Ricardo Martinez has prepared the following financial statement projections as part of his business plan for starting the Martinez Products Corporation.  The venture is to manufact

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