Convertible Bond Prices and Inherent Biases

Abstract

This examination of the pricing performance of a reduced-form convertible bond valuation model uses a recent sample of monthly U.S. convertible bond prices observed over January 2001–September 2002. Recent U.S. data help us understand the particular market. The model produces prices that are consistently lower than observed market prices when the embedded conversion option is in the money and higher than observed market prices when the conversion option is out of the money. Evidence from the sample suggests that the deep out-of-the-money bias is not related to the theoretical model's performance but rather the result of the fact that convertible bonds with low conversion value seem to be generally underpriced so much that their prices often imply negative embedded option values.