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.