Are convertible bonds underpriced? An analysis of the French market

Ammann, Manuel; Kind, Axel; Wilde, Christian

doi:10.1016/s0378-4266(01)00256-4

Cited by 91 publications

(86 citation statements)

References 16 publications

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“…Existing research includes the papers of King, 19 Carayannopoulos, 20 Carayannopoulos and Kalimipalli, 21 Buchan, 22 Ammann et al 23,24 and Alex and Chan. 25 A drawback of these studies is in the very limited number of instruments analysed and the short studied history of convertibles: King 19 performs his tests for 103 American convertible bonds for two calendar days, Buchan 22 analyses pricing models for only one day, Carayannopoulus 20 investigates 30 American bonds for 12 days, Ammann et al 23 examine 21 French convertibles for a 1.5-year history (from February 1999 until August 2000). In our research we investigate more that 1,500 CBs quoted on eight leading exchanges 26 and perform more than one million simulations (more than 2.5 years of historical data per instrument in average).…”

Section: Introductionmentioning

confidence: 99%

The pricing of convertible bonds within the Tsiveriotis and Fernandes framework with exogenous credit spread: Empirical analysis

Gushchin¹,

Curien²

2008

J Deriv Hedge Funds

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Victor Gushchin has an MS in Mathematics and Applied Mathematics and a PhD in Economics from Moscow State University. He is currently employed as Manager of the Financial Model Validation and QA Front Office teams for Sophis Technology Ireland. In this post, he is also responsible for developing and validating pricing models for convertible bonds and providing assistance to hedge funds in this respect.Erwan Curien was educated in mathematics and physics (Ecole Polytechnique, France, 1998), specialising in finance and statistics (ENSAE, 2001). He is currently employed as the manager of the Quantitative Research team for Sophis Technology France. In this post, he is also responsible for developing models for convertible bonds. He has published several articles on convertible bonds and credit derivatives. Practical applicationsOwing to its relative simplicity and its ability to incorporate the main characteristics of convertibles that have limited market data, the Tsiveriotis and Fernandes framework is widely used by practitioners for pricing convertible bonds. In our research, we addressed the most important unanswered question regarding the Tsiveriotis and Fernandes framework; does the framework provide accurate and practical valuation consistent with the market? We conducted what we believe is the most extensive empirical research on the subject and found that using a moving-average credit spread results in a valuation that is consistent with the market. The existence of a continuous credit spread that can be used to achieve accurate pricing establishes solid practical grounds for the hedging strategy based on historical implied credit spread that is used by many hedge funds. The co-integration of historical volatility and credit spread described in the article makes it possible, in many cases, to price convertibles without complete market information. Practical advice and examples are provided. AbstractDespite a huge popularity of convertible bonds and a variety of different pricing models, very little empirical research on their valuation has been undertaken. This paper investigates the pricing performance of arguably the most popular among practitioners, the Tsiveriotis and Fernandes approach implemented within a trinomial-tree model with exogenous credit spread using daily market prices on the largest available historical database (B1500 CBs). We demonstrate that using a constant credit spread within that framework would lead to significant mispricing in average. By contrast, we present a practical approach for valuing convertible bonds with moving-average credit spread, which leads to acceptable results. We prove that historical volatility and implied credit spread are cointegrated for the majority of bonds in our sample. This allows us to model credit spread based on cointegrated relationship with volatility and extend our model to the cases with limited market information available. The mispricing is proven to be statistically insignificant in the researched convertible bonds.

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Section: Introductionmentioning

confidence: 99%

The pricing of convertible bonds within the Tsiveriotis and Fernandes framework with exogenous credit spread: Empirical analysis

Gushchin¹,

Curien²

2008

J Deriv Hedge Funds

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show abstract

“…Unlike other studies that use bond spreads for pricing (see Tsiveriotis and Fernandes (1998), Ammann et al (2003), Zabolotnyuk et al (2010), and so on), we perform risky valuation based on credit information extracted from CDS spreads. Given the recovery rates and the CDS premia, we can compute the hazard rates via a standard calibration process (J.P. Morgan, 2001).…”

Section: Convertible Bond Case 1 (A 7-year Convertible) Case 2 (A 20-mentioning

confidence: 99%

“…Therefore, some authors, such as Ammann et al (2003), Loncarski et al (2009), Zabolotnyuk et al (2010, have to make do with historical volatilities. Similarly, we calculate the historical volatility as the annualized standard deviation of the daily log returns over the last 2 years (from September 10, 2010 to September 10, 2012), and then value the convertible bond based on this real-world volatility.…”

Section: Convertible Bond Case 1 (A 7-year Convertible) Case 2 (A 20-mentioning

confidence: 99%

“…In fact, it is believed that hedge funds purchase 70% to 80% of the convertible debt offered in primary markets. A prevailing belief in the market is that convertible arbitrage is mainly due to convertible underpricing (i.e., the model prices are on average higher than the observed trading prices) (see Ammann et al (2003), Calamos (2011), Choi et al (2009), Loncarski et al (2009, and so on). However, Agarwal et al (2007) and Batta et al (2007) argue that the excess returns from convertible arbitrage strategies are not mainly due to underpricing, but rather partly due to illiquid.…”

Section: Introductionmentioning

confidence: 99%

“…However, most liquid stock options have relatively short maturates (rarely more than 8 years). As a result, some authors, such as Ammann et al (2003), Loncarski et al (2009), Zabolotnyuk et al (2010), have to make do with historical volatilities. Therefore, we segment the sample into two sets according to maturity: a short-maturity class (0 ~ 8 years) and a long-maturity class (> 8 years).…”

Section: Introductionmentioning

confidence: 99%

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