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

Finance charges on credit card, Jack needs to borrow $1,000 for the next ye...

Jack needs to borrow $1,000 for the next year. Bank South will give him the loan at 9 percent. Suncoast bank will give him the loan at 7 percent with a $50 loan origination fee. Fi

Difference between pay-as-you-use and pay-as-you-go methods, Question 1: ...

Question 1: (a) Explain fully the difference between ‘Pay-As-You-Use' and ‘Pay-As-You-Go' methods of financing infra-structural projects. (b) Write short notes on any ONE of

The chinese pension fund system, The Chinese Pension Fund System Mainlan...

The Chinese Pension Fund System Mainland China has a rapidly aging population. This is attributable to two main factors - the one-child policy plus substantial improvements in l

How amount of financing affecting cost of capital, Q. How Amount of financi...

Q. How Amount of financing affecting cost of capital? Amount of financing as the financing require of the firm become larger , the weighted cost of capital increased several re

Show function of the financial decision, Q. Show Function of the Financial ...

Q. Show Function of the Financial decision? Financial decision: the second major decision is involved in financial management is the financial decision the investment decision

Describe the dividend yield method, Q. Describe the Dividend Yield Method? ...

Q. Describe the Dividend Yield Method? Dividend Yield Method: - This process is based on the assumption that when an investor invests in the equity shares of a company he expec

Determine the example of future value of an annuity, Determine the example ...

Determine the example of Future Value of an Annuity An annual payment of 7000 $ is invested at 5% per annum compounded yearly. What will be the amount after 20 years? Solut

Regulatory requirements for debentures, The following guideline...

The following guidelines are applicable for the issue of Fully Convertible Debentures (FCDs), Partly Convertible Debentures (PCDs) and Non-conve

Estimate the money in dollars have lost or gained, In January 2010 your fir...

In January 2010 your firm bought from an Italian firm goods payable in Euros worth EU2,000,000.  Suppose that at that time the exchange rate of the Euros was 1EU=$1.25.  Because th

Partial correlation coefficients , In multiple correlation equations we are...

In multiple correlation equations we are often interested in finding out how much of the variation in the dependent variable is explained by one independent variable if all the oth

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