Convertible bond

From WilmottWiki

The convertible bond is a contract on a stock that pays specified coupons periodically with return of the principal at maturity. However, the holder can at certain specified times convert the bond into a specified multiple of the underlying asset. A convertible bond thus has the characteristics of an ordinary corporate bond but with the extra feature that the bond may, at a time of the holder's choosing, be exchanged for a specified asset. This make the convertible bond a hybrid instrument.

The value of a CB is clearly bounded below by both

• conversion value, which is the amount received if the bond is converted immediately
• its value as a corporate bond, with a final principal and coupons during its life. This is called its straight value.

Uses of convertible bonds

Companies issue bonds for the purpose of raising capital. Corporate bonds come in many varieties. At one end there are the simple vanilla bonds, with fixed coupon and repayment of the principal at maturity. Most corporate bonds have a call provision so that the issuing company can call them back prior to maturity. They would do this if interest rates were to fall sufficiently below the then prevailing market rates. Some bonds have put provisions so that the holder can sell them back to the issuer prior to maturity. Because of the possibility of default corporate bonds are ranked according to precedence in receiving assets in the event of bankruptcy.

References

• Wilmott, P 2006 Paul Wilmott On Quantitative Finance, second edition}. John Wiley & Sons