1. Introduction
A company can raise capital in financial markets either by issuing
equities, bonds, or hybrids (such as convertible bonds). From an
investor’s perspective, convertible bonds with embedded optionality
offer certain benefits of both equities and bonds – like the former,
they have the potential for capital appreciation and like the latter,
they offer interest income and safety of principal. The convertible bond
market is of primary global importance.
There is a rich literature on the subject of convertible bonds.
Arguably, the first widely adopted model among practitioners is the one
presented by Goldman Sachs (1994) and then formalized by Tsiveriotis and
Fernandes (1998). The Goldman Sachs’ solution is a simple one factor
model with an equity binomial tree to value convertible bonds. The model
considers the probability of conversion at every node. If the
convertible is certain to remain a bond, it is then discounted by a
risky discount rate that reflects the credit risk of the issuer. If the
convertible is certain to be converted, it is then discounted by the
risk-free interest rate that is equivalent to default free.
Tsiveriotis and Fernandes (1998) argue that in practice one is usually
uncertain as to whether the bond will be converted, and thus propose
dividing convertible bonds into two components: a bond part that is
subject to credit risk and an equity part that is free of credit risk. A
simple description of this model and an easy numerical example in the
context of a binomial tree can be found in Hull (2003).
Grimwood and Hodges (2002) indicate that the Goldman Sachs model is
incoherent because it assumes that bonds are susceptible to credit risk
but equities are not. Ayache, et al. (2003) conclude that the
Tsiveriotis-Fernandes model is inherently unsatisfactory due to its
unrealistic assumption of stock prices being unaffected by bankruptcy.
To correct this weakness, Davis and Lischka (1999), Andersen and Buffum
(2004), Bloomberg (2009), and Carr and Linetsky (2006) etc., propose a
jump-diffusion model to explore defaultable stock price dynamics. They
all believe that under a risk-neutral measure the expected rate of
return on a defaultable stock must be equal to the risk-free interest
rate. The jump-diffusion model characterizes the default time/jump
directly.
The jump-diffusion model was first introduced by Merton (1976) in the
market risk context for modeling asset price behavior that incorporates
small day-to-day diffusive movements together with larger randomly
occurring jumps. Over the last decade, people attempt to propagate the
model from the market risk domain to the credit risk arena.
There are two primary types of models that attempt to describe default
processes in the literature: structural models and reduced-form models.
The structural models regard default as an endogenous event, focusing on
the capital structure of a firm. The reduced-form models do not explain
the event of a default endogenously, but instead characterize it
exogenously as a jump process. Many practitioners in the credit trading
arena have tended to gravitate toward the reduced-from models given
their mathematical tractability and market consistency.
Zhou (1997), Hilberink and Rogers (2002), Chen and Kou (2009), etc.
introduce the jump-diffusion mechanism into the structural models, while
Davis and Lischka (1999), Andersen and Buffum (2004), and Bloomberg
(2009), etc. add a default jump to the stock price dynamics. We refer to
the formers as the structural jump-diffusion models and the latters as
the reduced-form jump-diffusion models.
Although both the structural jump-diffusion model and the reduced-form
model contain jumps, these jumps have different meanings: A jump in the
structural jump-diffusion model corresponds to a sudden change in the
asset value that may or may not cause the firm to default, whereas a
jump in the reduced-form model represents the default event itself.
In this paper, we mainly discuss the reduced-form jump-diffusion models.
At the heart of the jump-diffusion models lies the assumption that the
total expected rate of return to the stockholders is equal to the
risk-free interest rate under a risk-neutral measure.
Although we agree that under a risk-neutral measure the market price of
risk and risk preferences are irrelevant to asset pricing (see Hull
(2003)) and thereby the expectation of a risk-free11Here,risk-free means free of credit risk, but not necessarily of
market risk asset grows at the risk-free interest rate, we are not
convinced that the expected rate of return on a defaultable asset must
be also equal to the risk-free rate. We argue that unlike market risk,
credit risk actually has a significant impact on asset prices. This is
why regulators, such as International Accounting Standards Board (IASB),
Basel Committee on Banking Supervision (BCBS), etc. require financial
institutions to report a credit value adjustment (CVA) in addition to
the risk-free mark-to-market (MTM) value to reflect credit risk (see
Xiao (2013)). By definition, a CVA is the difference between the
risk-free value and the risky value of an asset/portfolio subject to
credit risk. CVA implies that the risk-free value should not be equal to
the risky value in the presence of default risk. As a matter of fact, we
will prove that the expected return of a defaultable asset under a
risk-neutral measure actually grows at a risky rate rather than the
risk-free rate. This conclusion is very important for risky valuation.
Because of their hybrid nature, convertible bonds attract different type
of investors. Especially, convertible arbitrage hedge funds play a
dominant role in primary issues of convertible debt. In fact, it is
believed that hedge funds purchase 70% to 80% of the convertible debt
offered in primary markets. A prevailing belief in the market is that
convertible arbitrage is mainly due to convertible underpricing (i.e.,
the model prices are on average higher than the observed trading prices)
(see Ammann, et al (2003), Choi, et al. (2009), Loncarski, et al.
(2009), etc.). However, Agarwal, et al. (2007) and Batta, et al. (2007)
argue that the excess returns from convertible arbitrage strategies are
not mainly due to underpricing, but rather partly due to illiquid.
Calamos (2011) believes that arbitrageurs in general take advantage of
volatility. A higher volatility in the underlying equity translates into
a higher value of the equity option and a lower conversion premium.
Multiple views reveal the complexity of convertible arbitrage, involving
taking positions in the convertible bond and the underlying asset that
hedges certain risks but leaves managers exposed to other risks for
which they reap a reward.
This article makes a theoretical and empirical contribution to the study
of convertible bonds. In contrast to the above mentioned literature, we
present a model that is based on the probability distribution (or
intensity) of a default jump (or a default time) rather than the default
jump itself, as the default jump is usually inaccessible (see Duffie and
Huang (1996), Jarrow and Protter (2004), etc).
We model both equities and bonds as defaultable in a consistent way.
When a firm goes bankrupt, the investors who take the least risk are
paid first. Secured creditors have the best chances of seeing the value
of their initial investments come back to them. Bondholders have a
greater potential for recovering some their losses than stockholders who
are last in line to be repaid and usually receive little, if anything.
The default proceedings provide a justification for our modeling
assumptions: Different classes of securities issued by the same company
have the same default probability but different recovery rates. Given
this model, we are able to back out the market prices.
Valuation under our risky model can be solved by common numerical
methods, such as, Monte Carlo simulation, tree/lattice approaches, or
partial differential equation (PDE) solutions. The PDE algorithm is
elaborated in this paper, but of course the methodology can be easily
extended to tree/lattice or Monte Carlo.
Using the model proposed, we conduct an empirical study of convertible
bonds. We obtain a data set from FinPricing (2015). The data set
contains 164 convertible bonds and 2 years of daily market prices as
well as associated interest rate curves, credit curves, stock prices,
implied Black-Scholes volatilities and recovery rates.
The most important input parameter to be determined is the volatility
for valuation. A common approach in the market is to use the
at-the-money (ATM) implied Black-Scholes volatility to price convertible
bonds. However, most liquid stock options have relatively short
maturates (rarely more than 8 years). As a result, some authors, such as
Ammann, et al. (2003), Loncarski, et al. (2009), Zabolotnyuk, et al.
(2010), have to make do with historical volatilities. Therefore, we
segment the sample into two sets according to the time to maturity: a
short-maturity class (0 ~ 8 years) and a long-maturity
class (> 8 years). For the short-maturity class, we use the
ATM implied Black-Scholes volatilities for valuation, whereas for the
long-maturity class, we calculate the historical volatility as the
annualized standard deviation of the daily log returns of the last 2
years and then price the convertible bond based on this real-world
volatility.
The empirical results show that the model prices fluctuate randomly
around the market prices, indicating the model is quite accurate. Our
empirical evidence does not support a systematic underpricing
hypothesis. A similar conclusion is reached by Ammann and Wilde (2008)
who use a Monte-Carlo simulation approach. Moreover, market participants
almost always calibrate their models to the observed market prices using
implied convertible volatilities. Therefore, underpricing may not be the
main driver of profitability in convertible arbitrage.
It is useful to examine the basics of the convertible arbitrage
strategy. A typical convertible bond arbitrage employs delta-neutral
hedging, in which an arbitrageur buys a convertible bond and sells the
underlying equity at the current delta (see Choi, et al. (2009),
Loncarski, et al. (2009), etc.). With delta neutral positions, the sign
of Gamma is important. If Gamma is negative, the portfolio profits so
long as the underlying equity remains stable. If Gamma is positive, the
portfolio will profit from large movements in the stock price in either
direction (see Somanath (2011)).
We study the sensitivities of convertible bonds and find that
convertible bonds have relatively large positive gammas, implying that
convertible arbitrage can make a profit on a large upside or downside
movement in the underlying stock price. Since convertible bonds are
issued mainly by start-up or small companies (while more established
firms rely on other means of financing), the chance of a large movement
in either direction is very likely. Even for very small movements in the
underlying stock price, profits can still be generated from the yield of
the convertible bond and the interest rebate for the short position.
The rest of this paper is organized as follows: The model is presented
in Section 2. Section 3 elaborates the PDE approach; Section 4 discusses
the empirical results. The conclusions are provided in Section 5. PDE
implementation details, a binomial tree approach and a comparison of
models are contained in the appendices.
- Model
Convertible bonds can be thought of as normal corporate bonds with
embedded options, which enable the holder to exchange the bond asset for
the issuer’s stock. Despite their popularity and ubiquity, convertible
bonds still pose difficult modeling challenges, given their hybrid
nature of containing both debt and equity features. Further
complications arise due to the frequent presence of complex contractual
clauses, such as, put, hard call, soft call, and other path-dependent
trigger provisions. Contracts of such complexity can only be solved by
numerical methods, such as, Monte Carlo simulation, tree/lattice
approaches, or PDE solutions.
From a practitioner’s perspective, Monte Carlo is a “last resort” and
“least preferred” method, whereas lattice or PDE approaches suffer
from the curse of dimensionality: The number of evaluations and
computational cost increase exponentially with the dimension of the
problem, making it impractical to use in more than two dimensions.
Three sources of randomness exist in a convertible bond: the stock
price, the interest rate, and the credit spread. As practitioners tend
to eschew models with more than two factors, it is a legitimate
question: How can we reduce the number of factors or which factors are
most important? Grimwood and Hodges (2002) conduct a sensitivity study
and find that accurately modeling the equity process appears crucial.
This is why all convertible bond models in the market capture, at a
minimum, the dynamics of the underlying equity price. Since convertible
bonds are issued mainly by start-up or small companies (while more
established firms rely on other means of financing), credit risk plays
an important role in the valuation. Grimwood and Hodges (2002) further
note that the interest rate process is of second order importance.
Similarly, Brennan and Schwartz (1980) conclude that the effect of a
stochastic interest rate on convertible bond prices is so small that it
can be neglected. Furthermore, Ammann, et al. (2008) notice that the
overall pricing benefit of incorporating stochastic interest rates would
be very limited and would not justify the additional computational
costs. For these reasons, most practical convertible models in the
market do not take stochastic interest rate into account.
We consider a filtered probability space (,, , ) satisfying the usual
conditions, where denotes a sample space, denotes a -algebra, denotes a
probability measure, and denotes a filtration.
The risk-free stock price process can be described as
(1)
where denotes the stock price, denotes the risk-free interest rate,
denotes the volatility, denotes a Wiener process.
The expectation of equation (1) is
(2)
where is the expectation conditional on the .
Equation (2) tells us that in a risk-neutral world, the expected return
on a risk-free stock is the risk-free interest rate , i.e., the
discounted stock price under the risk neutral measure is a martingale
process.
Next, we turn to a defaultable stock. The defaultable stock process
proposed by Davis and Lischka (1999), Andersen and Buffum (2004), and
Bloomberg (2009), etc., is given by
(3)
where is an independent Poisson process with with probability and 0
otherwise, is the hazard rate or the default intensity, is the stock
price immediately before any jump at time t . The expectation of
is .
The expectation of equation (3) is given by
(4)
It is shown in equation (4) that the expected return of a defaultable
stock under a jump-diffusion model also grows at the risk-free interest
rate. Equation (3) is a simpler version of the Merton’s Jump-diffusion
model where the number of jumps is 1.
The jump-diffusion model was first proposed in the context of market
risk, which naturally exhibits high skewness and leptokurtosis levels
and captures the so-called implied volatility smile or skew effects.
Ederington and Lee (1993) find that the markets tend to have
overreaction and underreaction to the outside news. The jump part of the
model can be interpreted as the market response to outside news. If
there is not any outside news, the asset price changes according to a
geometric Brownian motion. Since the market price of risk and risk
preferences are irrelevant to asset pricing within the market risk
context, the expected rate of return to the stockholders is equal to the
risk-free rate under a risk-neutral measure.
However, we wonder whether it is appropriate to propagate the
jump-diffusion model directly from the market risk domain to the credit
risk domain, as credit risk actually impacts the valuation of assets.
This is why financial institutions are required by regulators to report
CVA. In fact, we will show in the following derivation that the expected
return of a defaultable asset under a risk-neutral measure is actually
equal to a risky rate instead of the risk-free rate. This conclusion is
very important for risky valuation.
The world of credit modeling is divided into two main approaches:
structural models and reduced-form (or intensity) models. The structural
models regard default as an endogenous event, focusing on the capital
structure of a firm. The reduced-form models do not explain the event of
default endogenously, but instead characterize it exogenously as a jump
process. In general, structural models are based on the information set
available to the firm’s management, such as the firm’s assets and
liabilities; while reduced-form models are based on the information set
available to the market, such as the firm’s bond prices or credit
default swap (CDS) premia. Many practitioners in the credit
trading arena have tended to gravitate toward the reduced-from models
given their mathematical tractability. The reduced-form models can be
made consistent with the risk-neutral probabilities of default backed
out from corporate bond prices or CDS spreads/premia.
In the reduced-form models, the stopping (or default) time of a firm is
modeled as a Cox arrival process (also known as a doubly stochastic
Poisson process) whose first jump occurs at default and is defined as,
(5)
where or denotes the stochastic hazard rate or arrival intensity
dependent on an exogenous common state , and is a unit exponential
random variable independent of .
It is well-known that the survival probability from time t tos in this framework is defined by
(6)
The default probability for the period (t, s ) in this framework
is defined by
(7)
We consider a defaultable asset that pays nothing between dates tand T . Let and denote its values at t and T ,
respectively. Risky valuation can be generally classified into two
categories: the default time approach (DTA) and the default
probability (intensity) approach (DPA).
The DTA involves the default time explicitly. If there has been no
default before time T (i.e., ), the value of the asset atT is . If a default happens before T (i.e., ), a recovery
payoff is made at the default time as a fraction of the market
value22Here we use the recovery of market value (RMV)
assumption. given by where is the default recovery rate and is the
market value at default. Under a risk-neutral measure, the value of this
defaultable asset is the discounted expectation of all the payoffs and
is given by
(8)
where is an indicator function that is equal to one if Y is true
and zero otherwise, and denotes the stochastic risk-free discount factor
at t for the maturity given by
(9)
Although the DTA is very intuitive, it has the disadvantage that it
explicitly involves the default time/jump. We are very unlikely to have
complete information about a firm’s default point, which is often
inaccessible. Usually, valuation under the DTA is performed via Monte
Carlo simulation.
The DPA relies on the probability distribution of the default time
rather than the default time itself. We divide the time period (t,
T ) into n very small time intervals () and assume that a default
may occur only at the end of each very small period. In our derivation,
we use the approximation for very small y . The survival and
default probabilities for the period (, ) are given by
(10)
(11)
The binomial default rule considers only two possible states: default or
survival. For the one-period (, ) economy, at time the asset
either defaults with the default probability or survives with the
survival probability . The survival payoff is equal to the market value
and the default payoff is a fraction of the market value: . Under a
risk-neutral measure, the value of the asset at t is the
expectation of all the payoffs discounted at the risk-free rate and is
given by
(12)
where denotes the risky rate and is called the (short) credit spread.
Similarly, we have
(13)
Note that is -measurable. By definition, an -measurable random variable
is a random variable whose value is known at time . Based on thetaking out what is known and tower properties of
conditional expectation, we have
(14)
By recursively deriving from t forward over T and taking
the limit as approaches zero, the risky value of the asset can be
expressed as
(15)
Using the DPA, we obtain a closed-form solution for pricing an asset
subject to credit risk. Another good example of the DPA is the CDS model
proposed by J.P. Morgan (1999).
The derivation of equation (15) takes into account all credit
characteristics: possibility of a jump to default and recovery rate. It
tells us that a defaultable asset under the risk-neutral measure grows
at a risky rate . The risky rate is equal to a risk-free interest
rate plus a credit spread. If the asset is a bond, the equation is the
same as Equation (10) in Duffie and Singleton (1999), which is the
market model for pricing risky bonds. The market bond model says that
the value of a risky bond is obtained by discounting the promised payoff
using the risk-free interest rate plus the credit spread33There
is a liquidity component in the bond spread. This paper, however,
focuses on credit risk only..
Under a risk-neutral measure the market price of risk and risk
preferences are irrelevant to asset pricing (see Hull (2003)) and
thereby the expectation of a risk-free asset grows at the risk-free
interest rate. However, credit risk actually has a significant impact on
asset prices. This is the reason that regulators, such as IASB and BCBS,
require financial institutions to report a CVA in addition to the
risk-free MTM value to reflect credit risk.
In asset pricing theory, the fundamental no-arbitrage theorems do not
require expected returns to be equal to the risk free rate, but only
that prices are martingales after discounting under the numeraire. For
risk-free valuation, people commonly use a risk-free bond as the
numeraire, whereas for risky valuation, they should choose an associated
risky numeraire to reflect credit risk. The expected return is that of
the numeraire.
If a company files bankruptcy, both bonds and stocks go into a default
status. In other words, the default probabilities for both of them are
the same (i.e., equal to the firm’s probability of default). But the
recovery rates are different because the stockholders are the lowest
priority in the list of the stakeholders in the company, whereas the
bondholders have a higher priority to receive a higher percentage of
invested funds. The default proceedings provide a justification for our
modeling assumptions: Different classes of securities issued by the same
company have the same default probability but different recovery rates.
According to equation (15), we propose a risky model that embeds the
probability of the default jump rather than the default jump itself into
the price dynamics of an asset. The stochastic differential equation
(SDE) of a defaultable stock is defined as
(16)
where is the recovery rate of the stock and is the risky rate.
For most practical problems, zero recovery at default (or jump to zero)
is unrealistic. For example, the stock of Lehman Brothers fell 94.3% on
September 15, 2008 after the company filed for Chapter 11 bankruptcy.
Similarly, the shares of General Motors (GM) plunged 32% on June 1,
2009 after the firm initiated Chapter 11 bankruptcy. A good framework
should flexibly allow people to incorporate different recovery
assumptions into risky valuation.
Equation (16) is the direct derivation of equation (15). The formula
allows different assumptions concerning recovery on default. In
particular, represents the situation where the stock price jumps to 0,
and corresponds to the risk-free case. The expectation of equations (16)
is
(17)
Equation (17) says that the expected return of a stock subject to credit
risk is equal to a risky rate rather than the risk-free rate. The risky
rate reflects the compensation investors receive for bearing credit
risk.
- PDE Algorithm
The numerical solution of our risky model can be obtained by either PDE
methods, tree approaches, or Monte Carlo simulation. In this paper, we
introduce the PDE procedure, but of course the methodology can be easily
extended to the tree/lattice or Monte Carlo algorithms.
The defaultable stock price process is given by
(18)
where is the dividend and .
The valuation of a convertible bond normally has a backward nature since
there is no way of knowing whether the convertible should be converted
without knowledge of the future value. Only on the maturity date, the
value of the convertible and the decision strategy are clear. If the
convertible is certain to be converted, it behaves like a stock. If the
convertible is not converted at an intermediate node, we are usually
uncertain whether the continuation value should be treated as a bond or
a stock, because in backward induction the current value takes into
account the results of all future decisions and some future values may
be dominated by the stock or by the bond or by both. Therefore, we
arrange the valuation so that the value of the convertible at each node
is divided into two components: a component of bond and a component of
stock, i.e. where denotes the equity part of the convertible bond and
denotes the bond part of the convertible.
Suppose that is some function of S and t . Applying Ito
Lemma, we have
(19)
Since the Wiener process underlying S and G are the same,
we can construct the following portfolio so that the Wiener process can
be eliminated.
(20)
Therefore, we have
(21)
In contrast to all previous studies, we believe that the defaultable
equity should grow at the risky rate of the equity including dividends,
whereas the equity part of the convertible bond should earn the risky
rate of the equity excluding dividends, i.e.,
(22)
So that the PDE of the equity component is given by
(23)
Similarly applying Ito Lemma to the bond part of the convertible , we
obtain
(24)
Let us construct a portfolio so that we can eliminate the Wiener process
as follows
(25)
Thus, we have
(26)
The defaultable equity should grow at the risky rate of the equity
including dividends, while the bond part of the convertible bond grows
at the risky rate of the bond. Consequently, we have
(27)
where is the recovery rate of the bond.
The PDE of the bond component is
(28)
Equations (23) and (28) are coupled through appropriate final and
boundary conditions reflecting the terms and conditions of each
individual convertible and need to be solved simultaneously. Convertible
bonds often incorporate various additional features, such as call and
put provisions.
The final conditions at maturity T can be generalized as
(29)
(30)
where N denotes the bond principal, C denotes the coupon,
denotes the call price, denotes the put price and denotes the conversion
ratio. The final conditions tell us that the convertible bond at the
maturity is either a debt or an equity.
The upside constraints at time are
(31)
where is the continuation value of the convertible bond, is the
continuation value of the bond component and is the continuation value
of the equity component. Equation (31) says that the convertible is
either in the continuation region or one of the three constraints
(called, put or converted). One can use finite difference methods to
solve the PDEs (23) and (28) for the price of a convertible bond.
- Empirical results
This section presents the empirical results. We use two years of daily
data from September 10, 2010 to September 10, 2012, i.e., a total of 522
observation days. This proprietary data are obtained from an investment
bank. They consist of convertible bond contracts, market observed
convertible prices, interest rate curves, credit curves, stock prices,
implied Black-Scholes volatilities, and recovery rates.