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

Importance of wbs in the project communication process, Due to the complex...

Due to the complexity of the tasks involved in many projects, communication of responsibility for those tasks is often helped by means of graphical planning techniques.

State the types of integration, State the Types of integration ...

State the Types of integration Types of integration Horizontal Target company has same operations, and is in the same industry

OPERATING CYCLE, DISCUSS THE APPLICABILITY OF AN OPERATING CYCLE TO APOULTR...

DISCUSS THE APPLICABILITY OF AN OPERATING CYCLE TO APOULTRY BUSINESS (BROILERS)

Annual effective rate, You have recently won the UniSA "log tossing" compet...

You have recently won the UniSA "log tossing" competition. The prize of $200 is supposed to be used to buy a 50-year subscription to "Log News" This appears to represent a consid

What are free cash flows, What are "free cash flows?" Free cash flows s...

What are "free cash flows?" Free cash flows signify the total cash flows from business operations that are available to be distributed to the suppliers of a firm's capital each

Explain common methods for controlling translation exposure, It is, usually...

It is, usually, not possible to totally eliminate both translation exposure and transaction exposure.  In few cases, the elimination of one exposure will as well eliminate the othe

How to find value of zero-coupon bond?, Illustration  Find ...

Illustration  Find out the value of zero-coupon bond when maturity value is Rs.1,00,000, discounting rate is 12%, and the period is 25.  Then,

OPERATING CYCLE, #discuss the applicability of operating cycle to poultry b...

#discuss the applicability of operating cycle to poultry business.

Periodic system, limitations of using a periodic inventory system

limitations of using a periodic inventory system

Forward rates, Now that we have seen how default-free theoretical rat...

Now that we have seen how default-free theoretical rate can be extrapolated from the treasury yield curve, let us see how some other additional information, like forwar

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