Premiums on Convertible Bonds: Comment

Cretien, Paul D.

doi:10.2307/2325429

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“…+ P3Ff(F) + 3yYd + IHHd +?s S + error (1) where B is the observed price of the convertible bond, S is the value of the stock into which the CB is convertible, f(F) is a function of the floor variable-the protection feature of the bond, Yd is the difference in income streams between the CB and the stock into which it is convertible; Hd is the difference in the holding or financing cost of the two. 2 The problem of nonsimultaneous transactions is discussed in [5]. About 20 per cent of the observed values of S exceed the observed values of B in WL's data.…”

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confidence: 87%

Premiums on Convertible Bonds: A Reply

Weil¹,

Segall²

1970

The Journal of Finance

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WEST AND LARGAY [7] (hereafter WL) make a straightforward point and they should be entitled to a straightforward reply. It should go about as follows: Weil, Segall, and Green [5] (hereafter WSG) defined the floor variable poorly and restricted their data sample in a way that obscured that fact. As a consequence, they found the floor variable to be statistically insignificant and thus of little value in explaining the premiums on a special class of convertible bonds. WL's definition is superior for the restricted data sample and better still for the expanded sample. WL find the floor variable statistically significant and, hence, valuable in explaining the premium of CB's for which the bond price is dominated by the market value of the stock and the premium is dominated by factors other than conversion terms.The paragraphs that follow provide an answer to the question, "how valuable is the floor?" The reader uninterested in how that question is answered and why the answer is complicated should refer to Table 1 and stop. WSG [5] attracted several comments [3, 4, 5]. Duvel's [3] important methodological criticisms of WSG have not been incorporated by WL; to make their empirical work commensurate with WSG, they used the same model. In redoing the empirical work reported here we use what we now believe to be the correct methodology, following Duvel.We had originally argued that the floor's value had been exaggerated. We found the floor to be worthless and we reported that result. WL show that we found the floor worthless because a) we did not define it properly and b) we systematically excluded from our sample those CB's (selling above straight debt value but below par) for which the floor feature is most valuable. This article takes up where WL's comment stops and thus is more an extension of their work than a reply.The remaining question is whether the received theory on convertible bonds has exaggerated the value of the floor feature. Since the received literature and our previous critics provide no numbers, we shall be content to give our estimates in Table 1 and not argue about whether those numbers are "large" or "small." We believe a valid conclusion from WL's data and our model is that when a CB ($100 par) sells for $50 or more above its straight debt value the value of the floor feature is not detectably different from zero.

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confidence: 87%

Premiums on Convertible Bonds: A Reply

Weil¹,

Segall²

1970

The Journal of Finance

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“…Cretien, Jr. [6] and Duvell [7], in their comments, fault Weil, Segall and Green, Jr. on their seemingly biased sample, without realizing that the approach taken implicitly recognizes the asymmetry in the valuation models which calls for stratifying sample observations on the basis of whether x or y dominates. Brigham [5] has anticipated this difficulty but his empirical work did not extend far enough to identify explicitly the basic asymmetry.…”

Section: Determinants Of Convertible Bond Premiumsmentioning

confidence: 99%

The Valuation of Convertible Bonds

Walter¹,

Que²

1973

The Journal of Finance

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THE INTENT of this paper is to supplement previous studies of convertible debentures [1], [5], [13], [15] in at least two respects. One, the specific influence of the so-called bond floor upon the risk premiums associated with convertible debentures is analyzed by reference to the market model developed by Sharpe [14] and Lintner [12]. Two, the effect of involuntary terminations upon the range of possible returns from holding convertible debentures is examined by means of a simulation model. Under the market model, convertible debentures-like their underlying common shares-are regarded as components of a risky market portfolio. Such assets differ from their underlying stocks in that they may be less responsive to the vicissitudes of the market and may therefore feature smaller premiums. The essence of the bond floor in the context of the market model is that it conditions covariability with the market.Despite the highly useful insights that it affords, the market model cannot cope effectively with the changing responsiveness of convertible debentures to the market (occasioned by varying ratios of stock conversion value to straight bond value) and with the stochastic process by which convertible debentures disappear from the scene. An alternative approach of Monte Carlo simulation is thus introduced to obtain comprehensive forecasts of rates of return on convertible debentures conditional upon the simulated behavior of the underlying stock.In the treatment that follows, the conventional model is first described for purposes of contrast. The market model and its limitations are then treated. The remaining sections deal with the simulation model, its behavioral inputs, and simulation results.

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Premiums on Convertible Bonds: Comment

Cited by 2 publications

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Premiums on Convertible Bonds: A Reply

Premiums on Convertible Bonds: A Reply

The Valuation of Convertible Bonds

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