In the previous chapter we reviewed convertible bond instruments and the features that differentiated them from conventional fixed interest bonds. In this chapter we consider the pricing and valuation of these securities.
17.1 Traditional valuation methodology
Let us consider another hypothetical security issued by ABC plc, a 20-year convertible bond with a coupon of 8%. “One” bond has a nominal amount of £100 and may be converted into 10 ordinary shares of ABC plc. In November 1999 the bond is trading at £102 and the underlying shares at £2.50. In 1999 the company paid a dividend of £0.08 per share, a dividend yield of 3.20%.
If an investor buys just £100 nominal of the convertible, the premium paid over a direct purchase ...