Pricing Convertible Bonds by Simulation

21 Pages Posted: 8 Dec 2006

See all articles by Ali Bora Yigitbasioglu

Ali Bora Yigitbasioglu

University of Reading - ICMA Centre

Naoufel El-Bachir

University of Reading - ICMA Centre

Date Written: May 2004

Abstract

Convertible bonds are complex hybrid securities subject to multiple sources of risk. Many exhibit exotic path dependent features. Monte Carlo method is usually the favorite choice for solving high-dimensional problems and pricing path dependent securities. This paper breaks away from the tradition established in the literature of pricing convertible bonds with finite difference and lattice methods, and suggests a simulation methodology for convertible bond pricing. We introduce the dividend process for convertible bonds, and formulate the pricing problem according to the probabilistic martingale approach. The proposed methodology deals with convertible bonds, subject to credit risk, with call and put features. The early exercise rules are estimated by means of least squares regressions as in Longstaff and Schwartz (2001). The accuracy of the simulation algorithm is tested in the context of a two factor model. The algorithm performs fairly well, and shows potential for further extension to include many complexities inherent in convertible bonds, as well as additional risk factors.

Keywords: Monte Carlo, American Options, Convertible Bonds, Intensity Model, Credit Risk

JEL Classification: C15, C63

Suggested Citation

Yigitbasioglu, Ali Bora and El-Bachir, Naoufel, Pricing Convertible Bonds by Simulation (May 2004). Available at SSRN: https://ssrn.com/abstract=950213 or http://dx.doi.org/10.2139/ssrn.950213

Ali Bora Yigitbasioglu

University of Reading - ICMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom
+44 (0)118 931 8239 (Phone)
+44 (0)118 931 4741 (Fax)

Naoufel El-Bachir (Contact Author)

University of Reading - ICMA Centre ( email )

Whiteknights Park
P.O. Box 242
Reading RG6 6BA
United Kingdom