Convertible Bond Valuation Using Implied and Realized Volatility

Summary

This convertible-bond research note describes a relative-value approach based on the embedded option. It first compares implied volatility with the underlying stock’s historical volatility: relatively low implied volatility is treated as evidence that the bond’s option component may be cheap, while relatively high implied volatility suggests it may be expensive. Because implied-volatility estimates can contain outliers, the research also proposes a normalized gap between theoretical option value and the convertible bond’s option value. A positive valuation gap indicates a potentially underpriced option, with purchases held until valuation normalizes.

The note reports that low-valuation selections had rising average cumulative returns and gives backtest statistics for the overall strategy: 21.11% annualized return, 1.26 information ratio, 24.14% maximum drawdown, and 55.76% daily win rate. It focuses on buying undervalued bonds because short selling is described as unavailable in practice. These results are historical and depend on a threshold estimated from past data; the note says threshold choice is difficult, so the figures do not establish future performance.

Key ideas

• The approach compares convertible-bond option value with a theoretical estimate and stock volatility.
• Low implied volatility relative to historical volatility is interpreted as potential option undervaluation.
• A normalized theoretical-versus-market option-value gap is offered to reduce sensitivity to implied-volatility outliers.
• The strategy buys bonds judged undervalued and holds them until valuation normalizes.
• Reported historical backtest results are sensitive to a difficult-to-set threshold and do not guarantee future returns.

Tags

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