Convertible Bond Valuation and an Implied Volatility Screening Factor

Summary

The study outlines China’s convertible bond market and develops a screening factor intended to identify bonds with relatively low embedded-option valuations. It decomposes convertible bond value into a discounted bond component and an option component. Under simplifying assumptions about conversion and contractual clauses, it uses a Black–Scholes framework and numerical inversion to estimate the embedded option’s implied volatility.

The proposed factor compares that implied volatility with the underlying stock’s realized volatility, then ranks bonds into groups at different rebalancing intervals. The reported backtests show a monotonic relationship across groups and stronger returns for the top group than the benchmark over the study period, with results varying by rebalance frequency. These are historical results from the stated sample; the document does not establish out-of-sample robustness. Its European-option approximation also simplifies the convertible’s more complex callable, resettable, and puttable features, and the factor may depend on modeling assumptions and execution costs.

Key ideas

• Convertible bond value is modeled as discounted bond value plus embedded option value.
• A simplified Black–Scholes setup is inverted numerically to estimate implied volatility.
• The screening factor uses the gap between option implied volatility and stock realized volatility.
• The study evaluates ranked portfolios at multiple rebalancing frequencies.
• Contractual features and simplifying assumptions limit how closely the model represents actual convertible options.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.