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

Cash budget, We need to have done some exploration work on all of the major...

We need to have done some exploration work on all of the major projects for inclusion in our prospectus, but of our $4m we need at least $1m in the bank to pay for all the listing

What are the types of major types of finance companies, What are the types ...

What are the types of major types of finance companies? There are three main types of finance companies: a. Sales finance institutions which make loans to customers of a cer

What do you mean by financial leverage, Q. What do you mean by Financial Le...

Q. What do you mean by Financial Leverage? Financial Leverage: - The financial leverage perhaps defined as the tendency of the residual net profit to vary disproportionately wi

What do you meant by yield, Q. What do you meant by Yield? Investment s...

Q. What do you meant by Yield? Investment should be in such securities which yield the highest return. However, safety should not be sacrificed at the expense of yield. How

Define moody or standard & poor credit ratings, Why do most international b...

Why do most international bonds have high Moody’s or Standard & Poor’s credit ratings? Answer:  Moody’s Investors Service and Standard & Poor’s offer credit ratings on several

Cost of redeemable preference share capital, Q. Cost of Redeemable Preferen...

Q. Cost of Redeemable Preference Share Capital? Cost of Redeemable Preference Share Capital: - Redeemable preference capital has to be returned to the preference shareholders s

Explain the competitive benchmarking, Explain the Competitive Benchmarking ...

Explain the Competitive Benchmarking Healthcare services or Hospital are compared to rival 'competition 'in the same industry for instance methods of patient care and levels o

Bond and Stock valuation, 2. Suppose a 12% coupon bond sells at par today; ...

2. Suppose a 12% coupon bond sells at par today; and three years from today, the required rate on the same bond is 8%. What is the coupon rate on the bond today and what will it be

Option-adjusted spread (oas) - total return, The horizon price ...

The horizon price can be determined by incorporating Option-Adjusted Spread (OAS) into a total return analysis. But this requires a valuation mo

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