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Valuing Convertible Bonds as Derivatives

November 1994 – A one-factor convertible model now used by many hedge funds.

Convertible bonds are derivative securities; they contain options on the underlying common stock and the strait debt of their issuer. In this paper, we describe a binomial wone-factor model for calculating their theoretical value.  The model assumes that all uncertainty in the future value of a convertible bond stems from the volatility of the underlying stock price.  It uses a credit-adjusted discount rate when calculating the present value of future cash flows, in order to account for the credit sensitivity of a convertible.

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