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Decomposing and valuing callable convertible bonds: a new method based on exotic options

Zhou, Qi-Yuan and Wu, Chong-Feng and Feng, Yun (2007): Decomposing and valuing callable convertible bonds: a new method based on exotic options.

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Abstract

In the framework of Black-Scholes-Merton option pricing models, by employing exotic options instead of plain options or warrants, this paper presents an equivalent decomposition method for usual Callable Convertible Bonds (CCB). Furthermore, the analytic valuation formulae for CCB are worked out by using the analytic formulae for those simpler securities decomposed from CCB. Moreover, this method is validated by comparing with Monte Carlo simulation. Besides, the effects of call clauses, coupon clauses and soft call condition clauses are analyzed respectively. These give lots of new insights into the valuation and analysis of CCB and much help to hedge their risks.

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