Reading 57: LOS j ～ Q 6- 10

6．Which of the following factors must be included in an option-based valuation approach to price a callable convertible bond?

A)   Stock prices only.

B)   Interest rates only.

C)   Interest rates and stock prices only.

D)   Interest rates, stock prices and their correlation.

The correct answer was D)

The valuation of convertible bonds with embedded call and/or put options requires a model that links the movement of interest rates and stock prices.

7．Which of the following is equal to the value of a noncallable / nonputable convertible bond? The value of the corresponding:

A)   straight bond.

B)   callable bond plus the value of the call option on the stock.

C)   callable bond minus the value of the call option on the stock.

D)   straight bond plus the value of the call option on the stock.

The correct answer was D)

The value of a noncallable/nonputable convertible bond can be expressed as:

Option-free convertible bond value = straight value + value of the call option on the stock.

8．Suppose the market price of a convertible security is $1,050 and the conversion ratio is 26.64. What is the market conversion price?

A)   $26.64.

B)   $39.41.

C)   $50.00.

D)   $1,050.00.

The correct answer was B)

The market conversion price is computed as follows:

Market conversion price = market price of convertible security/conversion ratio = $1,050/26.64 = $39.41

9．What is the market conversion price of a convertible security?

A)   the price that an investor pays for the common stock in the market.

B)   the price that an investor pays for the common stock if the convertible bond is purchased and then converted into the stock.

C)   the value of the embedded call option.

D)   the value of the security if it is converted immediately.

The correct answer was B)

The market conversion price, or conversion parity price, is the price that the convertible bondholder would effectively pay for the stock if she bought the bond and immediately converted it.

market conversion price = market price of convertible bond ÷ conversion ratio.

10．For a convertible bond with a call provision, to which of the bond’s embedded options can the Black-Scholes option model apply?

A)   The convertibility feature - Yes; The call feature - Yes.

B)   The convertibility feature - No; The call feature - No.

C)   The convertibility feature - No; The call feature - Yes.

D)   The convertibility feature - Yes; The call feature - No.

The correct answer was D)

The Black-Scholes model applies to the convertibility feature just as it does to the common stock. The Black-Scholes model is not appropriate for the call feature because the volatility of the bond cannot be assumed constant.