Pricing Convertible Bonds

Victor Karlsson

Centre for Mathematical Sciences
Mathematical Statistics
Lund Institute of Technology,
Lund University,

ISSN 1403-6342
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.