Pricing Convertible Bonds
Centre for Mathematical Sciences
Lund Institute of Technology,
In this Master's thesis a model for pricing convertible bonds will be proposed.
The traditional convertible bond pricing is based on a combination of a
non-convertible bond plus a long call. The problem is that such a model does
not take into consideration the volatility in the interest rate. This is
however not appropriate since the lifetime for a convertible bond often spans
over several years.
The new approach for pricing convertible bonds captures the stochastic features
of both the share price and the interest rate. A recombining quadranary tree
is built to model the behaviour of a convertible bond. In this way, the
volatility in the interest rate is taken into consideration. The new model
is flexible and the tree-algorithm is fast. It can be used for many types
of convertible bonds.