Convertible bonds give holders the right to exchange the bonds for common shares of the issuer at a stated ratio during a particular period. They are complex securities that blend the characteristics found in equity, debt, and option securities. As a result, traders and arbitrageurs have developed specialized terminology to describe various aspects of the marketplace. For the sake of simplicity, assume it is now January 1, 2012, and that a hypothetical convertible bond is denoted as XYZ convertible 2% 2016. Exhibit 34.1 describes the various parameters that characterize this convertible bond.

EXHIBIT 34.1 Summary of the Terms Offered by the XYZ Convertible 2% 2016 Bond

Fixed-Income Features
Issuer XYZ Company Inc.
Rating BBB
Coupon C = 2% (annual)
Issue date January 1, 2012 (today)
First coupon date December 31, 2012 (in one year)
Accrued interest 0
Maturity December 31, 2016 (in T = 5 years)
Nominal value $1,000
Risk-free rate Rf = 4% per year
Issuer credit spread CS = 400 basis points (bps) above the risk-free rate
Equity Features
Issuer XYZ Company Inc.
Stock price S0 = $100 per share
Stock price change volatility σ = 30% per year
Stock dividend None
Conversion Features
Conversion ratio CR = 8
Conversion price $125.00
Call protection None
Market Valuation
Convertible market price 90 (i.e., 90% of face value)
Parity 80 (i.e., 80% of face value)
Conversion premium 12.50%

The fixed-income features of the convertible ...

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