A report about convertible bonds, published by Sophis, a provider of cross-asset, front-to-back portfolio and risk management applications, says that accurate pricing can be obtained in the majority of cases, leading to reliable portfolio valuations and risk management. Pricing convertible bonds’ price is mainly a function of an equity factor with a default process, the report says.
The study analyzed historical prices of more than 1,500 convertible bonds over 17 years. It was conducted in response to the growing demand for more accurate methods of valuing these instruments due to their inherent complexity. There are volumes of existing academic research regarding convertible bonds pricing. However, most of the research remains largely theoretical as the models have not been widely tested in real world situations.
Sophis claims that this research, conducted with data collected by its Sophis CB team across the globe for 17 years, may be the most extensive into this space to date. Most importantly, results show that a one-factor equity model with a default process (Tsiveriotis and Fernandes model) is efficient in the majority of situations. Financial institutions can thus accurately price CBs with such a model that is fed with accurate data and that takes into account all types of clauses.
Victor Gushchin, senior financial engineer, Sophis Technology says, “Sophis wanted to empirically validate its convertible bonds model, which uses a traditional trinomial tree method along with an extensive coverage of market clauses. For that we used regression testing on more than 1,500 convertible bonds and over one million simulations. The work conducted brings five main contributions. First we challenged the Tsiveriotis framework in the Trinomial context and showed its consistency with advanced credit models under some assumptions. Then we investigated the use of constant credit spread and empirically proved that it leads to a considerable mispricing of convertible bonds. We also demonstrated that moving-average credit spread results in a valuation of convertible bonds, which is most of the time consistent with the market. Finally we proved co-integration of historical implied credit spread and historical volatility for most of the convertibles and showed that using that relationship produces a statistically insignificant mispricing for most instruments in our database.”
Sophis has published the white paper detailing its findings, which can be downloaded at www.sophis.net.