OVCV Model Description

David Frank
Quantitative Finance Development
Bloomberg L.P.

May 15, 2014

Abstract
This document details the Jump-Diffusion and Black-Scholes models used for Convertible bonds
in the function OVCV
Keywords. Convertible Bond, Model Description.

Contents
1 Introduction

2 The Stock Process Under the Jump-Diffusion Model

3 Derivation of the Convertible Bond PDE Under the Jump-Diffusion Model

4 Convertible Bonds Under the Black-Scholes Model

5 Convertible Bond Features

5.1

Dividend Protection . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5.2

Soft Calls With N-of-M Triggers . . . . . . . . . . . . . . . . . . . . . . . . . . . .

10

5.3

Contingent Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

5.4

Cross-Currency Convertibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

5.5

Mandatory Convertibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

11

5.6

Exchangeables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12

5.7

Reset Convertibles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12

5.8

Make-Whole Calls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

13

5.9

Dividend-Forfeit Clauses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

14

5.10 CoPay Clauses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

14

5.11 Mandatory Convertibles Averaging Period . . . . . . . . . . . . . . . . . . . . . .

14

6 Calibration of the Models

15

6.1

Calibration of the Black-Scholes Model . . . . . . . . . . . . . . . . . . . . . . . . .

15

6.2

Calibration of the Jump-Diffusion Model . . . . . . . . . . . . . . . . . . . . . . . .

15

6.3

Calibration of the Hazard Rate to the CDS Spread . . . . . . . . . . . . . . . . . .

16

7 Calibration With Stochastic Credit: the Equity-to-Credit Link

16

8 Delta and Gamma Calculations

19

9 Borrow Cost

20

10 Computation of Expected Life

20

Introduction

In this document, we describe the Jump-Diffusion and Black-Scholes models used for pricing convertible bonds in the function OVCV. We first describe the process followed by the stock price
under the Jump-Diffusion model. We then derive the partial differential equation (PDE) whose
solution gives the convertible bond price as a function of stock price and time under this model. We
then consider the Black-Scholes model, a subcase of the Jump-Diffusion model. Next, we discuss
the modeling of additional features of convertible bonds, such as dividend protection and soft calls.
Next we discuss model calibration, that is, how the model parameters are chosen to match input
volatilities and CDS spreads (in the Jump-Diffusion case). Next, we describe delta and gamma
calculation, and how borrow cost impacts the calculations. Lastly, we explain how we compute
expected life for convertibles.

The Stock Process Under the Jump-Diffusion Model

In this section, we describe the stock dynamics followed under the Jump-Diffusion model.
The convertible bond is priced using a one factor model. We assume the stock price follows the
usual Black-Scholes, lognormal stock process with time-dependent rates and volatilities, with the
addition of an independent Poisson process to model defaults. The following list describes notation
used throughout this document:
Bt
F
St
r
q

R
K
D
h

Wt
Ut

Bond price, including accrued interest (dirty price)

Face value (par value) of the bond
Stock price at time t
Time-dependent instantaneous forward interest rate
Time-dependent instantaneous forward continuous dividend rate
Time-dependent instantaneous forward volatility
The recovery rate
Time-dependent conversion ratio
The value of the convertible bond after default, including recovery
Time-dependent hazard rate
Fractional loss in the stock price on default
A standard Brownian motion
A Poisson process, independent of Wt
Time of (first) default

The lognormal stock process can be described as:

dSt = [r(t) q(t)] St dt + (t)St dWt

(1)

The addition to these dynamics of a jump in the stock price on default leads to the following
dynamics:
dSt = [r(t) q(t) + h(t)] St dt + (t)St dWt St dUt

(2)

where U is an independent Poisson process used to model defaults, with dUt = 1 with probability
h(t)dt, and 0 otherwise. The notation St is used to denote the stock price immediately before
any jump at time t. The parameter h(t) is known as the hazard rate. The hazard rate function is
calibrated to Credit Default Swap data if such data is available for the bond issuer. On default,
the stock price is assumed to jump downward by exactly the fraction of its pre-default value.
As with the Black-Scholes model for stock options, the model described above leads via the usual
arbitrage arguments to a PDE for the convert price. The actual solution method used is to solve
that PDE over a grid in the two dimensions of stock price and time, with boundary conditions
appropriate to the convertible bonds conversion, call, and put provisions. We derive the PDE in
the next section.

Derivation of the Convertible Bond PDE Under the JumpDiffusion Model

In this section, we derive the partial differential equation which holds for the price of a convertible
bond with default risk under our model. Henceforth we employ subscripts on the variable B to
denote partial derivatives of the convertible bond price.
First, consider the case of the convertible bond without default, that is, where h(t) is zero in
equation (2). If we form a portfolio consisting of one convertible bond and shares of the
stock, then by Itos Formula we arrive at the following PDE for changes in the value of this portfolio:



1
2 2
d = Bt + (t) S BSS dt + BS dS (dS + q(t)Sdt)
2
Using the standard Black-Scholes argument, we can eliminate risk from the portfolio by choosing
= BS , in which case the portfolio must grow at the risk free rate. We can thus derive a PDE for
the bond price under the no-default assumption.
With the addition of the risk of default, we arrive at the Jump-Diffusion model. We assume that
the probability of default in the interval [t, t + dt] is h(t) dt, and that after default, the bond value
falls to some value D, a function of R and other factors (we provide the exact form of D later).
Then, assuming default risk is fully diversifiable, there is no excess expected return above the risk

5
free rate earned for holding credit risk. We can then form a portfolio as above but now including
one risky convertible bond and shares of the stock. The change in value of this portfolio is
given by
d =




1
2 2
[1 dUt ] Bt + (t) S BSS dt + BS dS
2
h
i
[1 dUt ] dS + q(t)S dt
dUt

[(D B) + S]

where the first line contains terms that represent the change in the value of the bond if there is no
default during the period dt, the second line has terms that represent the change in value of the
short stock position if there is no default, and the third line is the change in value of the bond and
short stock when there is a default.
If we now eliminate the stock risk from the portfolio by again choosing = BS , and take expectations with respect to the risk neutral measure we find

E[d] =




1
2 2
[1 h(t) dt ] Bt + (t) S BSS dt + BS dS
2
h
i
[1 h(t) dt ] BS dS + BS q(t)S dt
h(t) dt

[(D B) + SBS ]

Now by eliminating terms of order higher than dt and by dropping the canceling dS terms, the
equation reduces to


h
i
1
2 2
E[d] = Bt + (t) S BSS dt BS q(t)S dt + h(t) D B + SBS dt
2

(3)

The assumed diversifiability of credit risk implies that the expected return on the portfolio is again
the risk free rate:
r(t) dt = E[d],

where

= B BS S

This last equation combined with (3) gives us the PDE which we solve to price the convertible
bond under Jump-Diffusion. Direct substitution into (3) gives:


h
i
1
2 2
r(t) (B BS S) dt = Bt + (t) S BSS dt BS q(t)S dt + h(t) D B + SBS dt
2

By dividing out dt and simplifying, we find

1
[r(t) + h(t)] B = Bt + (t)2 S 2 BSS + [r(t) q(t) + h(t)] BS S + h(t)D
2
Assuming the value on default D is the maximum of the recovery value on the bond, and the
remaining post-default conversion value, this leads to the final PDE:

1
[r(t) + h(t)] B = Bt + (t)2 S 2 BSS + [r(t) q(t) + h(t)] BS S + h(t) max[ RF, K(t) S(1 ) ] (4)
2
We solve the above equation with further modifications to handle discrete dividends and coupon
payments. Further, the convertible bond may have time-varying put, call, and conversion features.
These are modeled as constraints which are enforced when the various features are in effect. Sometimes, these constraints are simple, and they are applied in an obvious, straightforward manner,
e.g. capping the value of the bond at the hard call price at points on the grid where the hard
call is in effect. In other cases, the constraint is more complex, and the techniques used to enforce
the constraint are more complicated, as discussed below in the sections on the various convertible
bond features.

Convertible Bonds Under the Black-Scholes Model

Under the Black-Scholes model, the stock price follows the lognormal process given in equation
(1). The Black-Scholes model can be viewed as a subcase of the Jump-Diffusion model, where the
hazard rate h(t) is zero for all times t. Equation (2) reduces to equation (1) when h(t) is zero
because the term dUt is zero with probability one, and so the terms h(t) and St dUt both drop
out of equation (2). Since there are no jumps under Black-Scholes, the stock process is continuous
almost surely, and thus St and St are the same. When Pricing a bond under the Black-Scholes
model, we solve the same PDE as under Jump-Diffusion, but with the hazard rate h(t) set to zero.
The Black-Scholes model accepts as input an OAS level. In solving the PDE under Black-Scholes,
we add the OAS to the time-dependent instantaneous forward interest rate r(t). Thus, the OAS
is applied as a parallel shift to the instantaneous forward curve.

Convertible Bond Features

In this section, we describe how we model various popular convertible bond features currently
supported by OVCV.

5.1

Dividend Protection

Dividend Protection typically provides an upward adjustment to the conversion ratio triggered by
payment of a dividend in excess of a specified threshold. The threshold may be specified as an
absolute amount or as a percentage of the stock price, while dividends may be similarly specified
as either absolute or proportional dividends. To describe our approach to modeling dividend
protection, we first provide formulae for the two forms of conversion ratio adjustment supported
by the model, then describe the numerical approach to modeling with this feature, and finally, we
provide some comparative results showing the effect of dividend protection on bond prices.
We will use the following notation in the discussion of dividend protection:
S
CR0
CR1
D(t)
DR (t)
T (t)
K(t)

The stock price prior to the ex-dividend date

Conversion ratio before the ex-dividend date, i.e. pre-adjustment
Conversion ratio after the ex-dividend date, i.e. post-adjustment
Discrete dividend(s) paid over the relevant period up to time t
D(t)/S, i.e. the dividend yield over the relevant period up to time t
Threshold level above which dividend protection is applied.
Trigger level which must must be reached for dividend protection to take effect

Note that we must have T K, and in the vast majority of cases, T = K.

Form 1 - Absolute Dividend Protection: This form of dividend protection adjusts the conversion ratio for absolute (that is, actual) dividends in excess of a given cash amount. In the simplest
case,

CR1 = CR0

S
SC

where S is the stock price prior to the ex-dividend date, and C is the cash dividend paid in excess of
a threshold amount T . That is, C = max(D(t) T, 0), where D(t) is the actual dividend amount.
An additional level of complexity is added if the threshold amounts T are a function of time, i.e.
replace T by T (t), giving

CR1 = CR0

S
S max(D(t) T (t), 0)

Finally, we can add a higher trigger level K, where we allow for dividend protection when the
dividend is in excess of K, but providing protection down to the lower threshold level T , leading
to the first modeled form of dividend protection:
CR1 = CR0

S
S if(D(t) > K(t), D(t) T (t), 0)

(5)

Form 2 - Relative Dividend Protection: This form of dividend protection adjusts the conversion ratio for dividends in excess of a given percentage of the then-current stock price. The dividend
protection is similar to Form 1, except the protection is based on the dividend yield rather than
the absolute dividend amount.
In the simplest form, CR1 = CR0 [1+max(DR T, 0)], where T is again the threshold above which
the conversion ratio is adjusted (now as a percentage, e.g. .02 for 2 percent), and DR , the dividend
yield, is calculated by dividing the total dividends in the relevant period by the last observed share
price.
An added level of complexity is introduced if dividends above trigger K percent are protected and
then you get protection for the part above the lower threshold T , leading to
CR1 = CR0 [1 + if(DR > K, DR T, 0)]

Generalizing this to time dependent thresholds and triggers gives

CR1 = CR0 [1 + if(DR (t) > K(t), DR (t) T (t), 0)]

(6)

Modeling the Conversion Ratio Adjustment: Under both forms of dividend protection,
the modeled future dividends at a given time may depend on the stock price (for proportional
dividends), and the threshold may also depend on the stock price (for a proportional threshold).
This dependency is handled in the model by adjusting the dividends and the threshold at each
node of the PDE grid as required.
Modeling dividend protection thus requires keeping track of the evolution through time of the
conversion ratio as a function of stock price and time. The evolution of the conversion ratio
through time will in general depend on the path taken by the stock price through time (rather
than depending only on the realized stock price at some future horizon date; that is, how we get
to the end point matters). We model dividend protection by adding an additional state variable
for the conversion ratio to the PDE grid. The PDE is solved in the usual manner for each of many
conversion ratio levels, that is, as if the different conversion ratio level grids were independent PDE
grids, except that at the designated dividend protection observation times values flow from one

9
level to the next as determined by the dividend protection adjustment to the conversion ratio at
each grid point. The modeling approach of adding a second state variable for the conversion ratio
fully captures the dependency of the conversion ratio on the stock price path.
Effect of Dividend Protection on Bond Pricing: Next we present some results showing
the effect of dividend protection on convertible bond theoretical prices. We consider a 5 year
convertible bond with current stock price 9, convertible any time at a strike of 10, r=3%, d=2.5%,
vol=25, with a 5 year default probability of .133, equivalent to a flat CDS spread of approximately
170bps. The following plot compares this bond with absolute dividend protection to an otherwise
identical bond with relative dividend protection, starting from comparable thresholds. We use a
proportional dividend assumption, at a 2.5% percent annual rate, paid quarterly. (We remark
that assuming known absolute dividends over the life of a convertible bond having more than say,
one year to maturity, seems to conflict with the typical stock volatility that would allow the stock
price to range over a factor of 5, 10, or larger; that is, assuming dividend payments remain the
same regardless of the path the stock price takes seems contradictory to both expectations and
experience).
The x-axis indicates the level above which dividend protection adjustments are done. In the relative
protection case, the x-axis simply indicates the identical percentage threshold and trigger levels
(T (t) and K(t)), while in the absolute protection case, the threshold and trigger levels are set to
the absolute dividend level that is the x-axis percentage of the initial stock price.
We see that in the case of full protection (level zero on the x-axis), the two forms are nearly
identical, but for partial protection, absolute protection produces a higher theoretical bond price.
Since the dividends are set at 2.5%, with relative protection at or above that level the bondholder
receives no benefit from dividend protection. But with an absolute threshold set at 2.5% of the
initial stock price (that is, at $0.25), if the stock runs up the absolute amount of the dividends
will be 2.5% of the larger stock price and will exceed the threshold, thus causing a conversion ratio
adjustment and still providing some dividend protection value to the holder. But for a sufficiently
large threshold (in this case, around 9.5-10.0%), the increase in the level of stock price required for
the dividend to exceed the threshold has such a small probability that the effect becomes negligible,
and the convert price under the two forms of protection converge to a common value.

10

Absolute and Relative Dividend Protection Vs. Protection Threshold

116
Absolute Dividend Protection
Relative Dividend Protection

Bond Price Per 100

115

114

113

112

111

110

109

10

Dividend Protection Threshold Percentage

5.2

Soft Calls With N-of-M Triggers

N-of-M triggers are seen in soft calls, and also in contingent conversion provisions. Both of these
provisions allow some action at time t (for soft calls, the issuer may call the bond, for contingent
conversion, the holder may convert) provided the stock price S() has exceeded some given barrier
B(t) for N (possibly consecutive) days of the last M consecutive days, where N M ; typical
values for N-of-M provisions are 20-of-30. Exact modeling of such contract provisions is extremely
time consuming, requiring a prohibitive 2M PDE grid levels for an exact solution. We model these
provisions by calculating an equivalent barrier B (t) such that the probability of S() exceeding
the barrier B(t) for the required N of the previous M days is equal to the probability of the
S(t), the stock at time t, exceeding B (t). (As N is required to be consecutive days or not effects
the probability calculation, and we take this difference into account). This reduces the N-of-M
barrier to an equivalent 1-of-1 barrier. We then apply the relevant constraint at time t based on
the equivalent barrier B (t). This approximation captures most (but not all) of the value of soft
call and contingent conversion provisions, and the technique is widely used in the market. The
equivalent barrier B (t) for the least applicable time t (that is, the earliest time at which there is
an N-of-M trigger) is shown in OVCV as the Effective Trigger.

11

5.3

Contingent Conversion

Contingent conversion provisions add several subtleties to the modeling. A straightforward application of contingent conversion is possible when the stock price is observed at time t to determine
convertibility at time t. However, the more common form of contingent conversion requires periodic
(typically, quarterly) observation to determine whether conversion is allowed over the subsequent
period. We model this provision by use of a discrete state variable to track whether or not the
last observation allowed conversion, and thus solve the PDE in two distinct and independent grids,
one where contingent conversion is always allowed, one where contingent conversion is never allowed. As we move backward in time to solve the PDE numerically, when we cross the periodic
observation times we get values from one plane or the other depending on whether the condition
for contingent conversion is satisfied at a particular node. An additional complexity which must
be modeled arises from the standard provision waiving the contingent conversion requirement in
the event of a call. In such case, the issuer will not call even if the bond price is above the call
price, if such a call benefits the holder by then allowing an advantageous early conversion. We use
appropriate tests in the PDE grid to avoid issuers making such disadvantageous call decisions.

5.4

Cross-Currency Convertibles

When the bond is issued in a different currency from the one in which the underlying stock is
denominated, we assume currency exchange rates are fixed and price the bond entirely in the bond
currency. That is, we model the stock process as if it traded in the bond currency rather than the
stock currency, and convert all stock-currency values to bond currency at the appropriate forward
rate.
We treat the stock price in the bond currency as the new underlying variable. The FX volatility and
correlation between the stock price and exchange rate impact the stock process in the bond currency.
We use a term structure F X (t), which is calibrated from the FX at-the-money volatilities. The
volatility of the new underlying (stock in bond currency) is then effectively
q
Equity (t)2 + F X (t)2 + 2 Equity (t)F X (t)
where is the correlation between (1) percentage move of stock price in its own currency and (2)
percentage move of foreign exchange rate, in units of stock currency per bond currency.

5.5

Mandatory Convertibles

Distinctive handling for mandatory convertibles includes the use of a final boundary condition
reflecting the final payoff, and use of two input volatilities, to capture the fact that the payoff
resembles positions in options with two distinct strikes. The two input volatilities are used to
create a local volatility surface, and the bond is priced using this local volatility surface.

12

5.6

Exchangeables

Exchangeable bonds are convertible issues where the conversion is into a stock other than that of
the issuer. Thus, of the two credits one might consider (that of the issuer, or that of the company
whose stock is received on conversion), the credit having the largest impact on such a bond is that
of the issuer. The issuers credit is generally of greater import since an issuer default will impair the
ability to collect coupons and principal, and possibly, the stock as well, depending on the presence
or absence of an escrow or trust holding the stock for safe conveyance even in the event of issuer
default. For this reason we use the issuers credit when pricing Exchangeables.
Since we are not using the credit of the stock, the stock is assumed to follow the process in the
Black-Scholes model, that is, geometric brownian motion, without jumps, and we currently assume
no correlation between the stock price and issuer hazard rates. However, though there are no stock
jumps, when using the Jump-Diffusion model, we still model issuer defaults. This occurs due to
the presence of the recovery term in the final PDE solved to price the bond, Equation (4). In the
case of exchangeables, the values of h(t) multiplying B and BS are set to zero, since those hazard
rates represent the hazard rate associated with the stock. But the hazard rate h(t) multiplying
the recovery term is the issuer hazard rate, and this term is still present in the PDE. Note also
that the recovery term for exchangeables has a different form from that given in Equation (4). In
the event of default, the payoff is based on the recovery rate and whether the stock is pledged by
the issuer or not. For pledged stock, the payoff to the holder on default is the greater of recovery
value or the full conversion value into stock. For unpledged stock, the payoff is recovery value
based on a bankruptcy claim on the larger of the face value and the full conversion value, that is,
the bankruptcy payoff is the assumed bond recovery times the larger of face value and stock price
times conversion ratio.

5.7

Reset Convertibles

Reset Convertibles are convertibles where the conversion ratio is reset based on the stock price
behavior, typically by resetting the conversion ratio upward if the stock price falls more than some
threshold level. Resets can be categorized as either static or dynamic resets. Dynamic resets are
characterized by the fact that the conversion ratio can reset at any time, whereas for a static reset
the conversion ratio is reset at fixed observation times. We handle static resets, but not dynamic.
Static resets are defined as follows. There is a date schedule consisting of a set of pre-determined
dates {tk , k = 1 n} which we call reset dates. At each reset date tk , the reference price (usually
defined as the Volume Weighted Average Price (VWAP) of the underlying stock over a certain
time period immediately prior to the reset date) is calculated. If the reference price is lower than
the trigger level Pk defined in the bonds term sheet, the conversion price is reset to a level which
is the product of the reference price and a gearing factor gk . For the majority of convertibles which
have reset features, the conversion price can be reset downward only to compensate investors for a
decrease in the bonds parity value. In most cases, we also find the reset of the conversion price is
bounded from below by a reset price floor, which puts a limit on this kind of protection.

13

We have found there are two ways to define the trigger level: either it is defined as an absolute stock
price level (or equivalently, the percentage pk of the initial conversion price), or as the percentage
pk of the prevailing conversion price immediately prior to the reset date. Similarly, the reset price
floor is defined either as the percentage fk of the initial conversion price, or the precentage fk of
the prevailing one.
Modeling of static resets uses the same approach as modeling of dividend protection. We use the
conversion ratio as an additional state variable. Assume that at time tk ,the kth element of the
reset schedule, the associated trigger level is pk (in percentage), the reset price floor is fk (also
in percentage), the gearing factor is gk , the face or par value of the bond is F , and the initial
conversion price is K. For the node (Si , CRj ) on the 2-dimensional PDE grid, at time tk , we
j using the following formula:
update CRj to CR
j=
CR

CRj
max(CRj , min(Ck , SiFgk ))

if Si >= Pk
otherwise

where the real trigger level Pk is defined as:

(
Pk =

K pk if pk is defined as a percentage of the initial conversion price

pk if pk is defined as a percentage of the prevailing conversion price

F
CRj

and the cap Ck is defined as:

(
Ck =

F
Kfk
CRj
fk

if fk is defined as a percentage of the initial conversion price

if fk is defined as a percentage of the prevailing conversion price

The reset of the conversion price can also additionally be floored by an absolute number P . In this
case the updating formula is changed to:
j=
CR

CRj
max(CRj , min(Ck , F , SiFgk ))
P

if Si >= Pk
otherwise

Except for conversion ratio updates as described here at reset dates, we strictly follow the method
defined in the section on modeling the conversion ratio adjustment on page 8 to solve the twodimensional PDE.

5.8

Make-Whole Calls

A Make-Whole call provision is a conditional payment usually contingent on a soft call, but possibly
on a hard call. During the soft call period, when the convertible is called and (or) investors are
forced into conversion following a call, investors are entitled to a lump sum payment which is the

14
present value of future coupons they wont get because of the early call. The PV calculation is
based on a constant yield or a benchmark yield curve (usually the Treasury curve) plus some spread.
Since the Make-Whole provision raises the call value and the conversion value simultaneously, it
significantly decreases the chance of the bond being called early.

5.9

Dividend-Forfeit Clauses

The Dividend-Forfeit clause is quite typical for French convertibles. For bonds with this feature, on
conversion, issuers can choose between delivering existing shares, which are called treasury shares,
and issuing new shares and delivering them to the bond holder. The newly issued shares are not
entitled to the dividend(s) being paid in the current fiscal year. Since it is therefore advantageous
for the issuer to deliver new shares, we assume they will.
In OVCV, we adjust a bonds conversion value if it has a Dividend-Forfeit clause. At the valuation
time s, we find the cut-off time t of the fiscal year in which s belongs to, and calculate the dividend
payment A between time s and time t based on the following formula:
A=

n
X

er(ti s) [(1 eq(ti ti1 ) )St + Di ] + er(ts) (1 eq(ttn ) )St

i

i=1

where t0 = s < t1 < < tn t, and {tj }nj=1 are ex-dividend dates over the time period (s, t).
Di is the cash dividend being paid at time ti and St is the stock price immediately before ti . We
i
then substract the product of A and the conversion ratio from the bonds conversion value at time
s.

5.10

CoPay Clauses

For some convertible bonds, a CoPay clause is added to sweeten the deal. At the i-th coupon
payment day which falls into the CoPay period, if the close price of the bond at that day is higher
than an upper barrier H or lower than a lower barrier L, the coupon payment for the i + 1-th
coupon period will be adjusted upward. The amount of the additional payment is determined as
a percentage of either the principle F , or the bond price at the i-th coupon payment day. In the
latter case, we use the bond price at the i + 1-th coupon payment day as an approximation and
calculate the value of the additional payment.

5.11

Mandatory Convertibles Averaging Period

Usually for a mandatory convertible bond, the conversion ratio at the maturity is determined
by the applicable market value, which is the average of the daily volume weighted average
prices (VWAPs) of the common stock for the N (typically 20) consecutive trading days ending
M (typically 3) days before the maturity. When inside the N + M day period before maturity,
we take the applicable historical stock prices into account when we decide the conversion ratio at
maturity.

15

Calibration of the Models

Calibration of a model is the process of finding model parameters such that the calibration instruments are priced by the model to match the market prices for those instruments. In this case,
the calibration instruments are vanilla european calls on the convertibles underlying stock, and,
for the Jump-Diffusion model, CDS prices appropriate to the credit characteristics of convertible
bond.
Black-Scholes volatilities are by definition the volatilities used in the Black-Scholes SDE for the
stock, that is, equation (1), when (t) is constant. Black-Scholes volatilities are what is commonly
quoted in the market; therefore, Black-Scholes volatilities are used in OVCV as user input to
indicate the market prices of the vanilla options. As distinguished from Black-Scholes volatilities,
we will refer to the (t) seen in equation (2) as jump-diffusion volatilities, since these volatilities
drive the part of the jump-diffusion stock process without the jumps. Given a set of Black-Scholes
volatilities, we must calibrate the model to determine the jump-diffusion volatilities which correctly
match the option prices.

6.1

Calibration of the Black-Scholes Model

In the case of the Black-Scholes, there is nothing to calibrate. The input volatilities (t) (whether
a single value or time-dependent) are used directly in the PDE. The only additional computation
is that in the case of time-dependent volatilities, the term structure of volatilities is converted
to instantaneous volatilities assuming piece-wise constant instantaneous volatilities between the
supplied term points.

6.2

Calibration of the Jump-Diffusion Model

In the case of the Jump-Diffusion model, our goal is to determine a term structure of jump-diffusion
volatilities which correctly price options at each term in the OVCV Volatility Tab term structure,
out to the bond maturity. If a flat volatility is used, we treat the flat volatility as if it were
the quoted volatility at every term on the Volatility Tab term structure; and if E2C is used, we
must jointly calibrate hazard rates and volatility, so we consider the union of the terms on the
Volatility Tab and the Credit Tab. (We describe calibration with E2C in more detail in the next
section). Now we proceed to find piecewise-constant jump-diffusion volatilities by bootstrapping,
that is, taking each term in sequence. For the first such term, we determine the constant (t)
such that an option priced under the Jump-Diffusion process, with that jump-diffusion volatility,
matches the BS price using the Black-Scholes volatility. For each subsequent term, we extend the
piecewise constant function (t) from the previous term so that this terms option priced under
the Jump-Diffusion process, with that volatility function, matches the Black-Scholes price using
the Black-Scholes volatility.

16

6.3

Calibration of the Hazard Rate to the CDS Spread

We convert the CDS spread into piecewise-constant hazard rates using the CDS model described
in DOCS 2057273. This CDS model gives us the time-dependent hazard rates h(t) used in the
PDE we solve, equation (4).

Calibration With Stochastic Credit: the Equity-to-Credit Link

Under the model as specified by the PDE of equation (4), the hazard rate at some future time t
does not vary as St is higher (or lower) relative to the original stock price S0 . This is counter to our
expectation that as the companys stock rises (falls) we would expect a concomitant improvement
(deterioration) in credit quality. That is, we expect the future hazard rate to vary inversely to
the future stock price. Equity-to-Credit (E2C) adds a link between the future stock price and the
future hazard rate which models this behavior. We first calibrate a time-dependent base hazard
rate h0 (t) and then use this to determine the future hazard rate at time t as a function of both t
and St :

h(St , t) = h0 (t)

S0
St

p

where p is a positive parameter which can be interpreted as the ratio of the stocks jump-diffusion
volatility to the spread volatility (as shown for the case where = 1 in the paper Calibration and
Implementation of Convertible Bond Models by Andersen and Buffum).
The calibrated values h0 (t) must preserve the expected hazard rates (expectation with respect to
the stock price) implied by the CDS spreads. Thus, the calibration problem at a time t is as follows:
if g(t) is the expected hazard rate at time t as calculated from CDS data, then g(t) is conditioned
on survival until time t, and so we must have (letting represent the default time)

 p 

 

S0 
1 
p
g(t) = E[h(t, St )| t] = E h0 (t)
 t = h0 (t)S0 E p  t
St
St
This last equation is solved to determine h0 (St , t). We also point out that the volatilities used in
the jump-diffusion must be calibrated such that options are priced consistently with market prices
under the stock process including the E2C link. Since a change in the diffusion volatilities affects
the expectation on the right-hand side of the last equation where we determine h0 (t) and a change
in h0 (t) affects the pricing of options, we jointly calibrate the jump-diffusion volatilities and h0 (t).
We next show some calibration results. Here, for various values of p, we show the effect of converting Black-Scholes volatilities to Jump-Diffusion volatilities, and we show the function h0 (t). We
calibrate to a flat volatility of 40% for calls struck at the ATM-forward, with an initial stock price

17
of 50, r(t) = 4%, d(t) = 2%,, and a constant credit spread of 5% (so the survival probability up to
any time T is simply e.05T ). The calibration fit was performed in monthly increments. (For the
sake of comparison, this example was chosen to be identical to the calibration example shown in
Figure 6 of Andersen and Buffums paper).
Here we show the calibrated function h0 (t) for various values of p:

Hazard Rates: h

0.1
0.09
0.08
0.07
0.06
0.05
0.04
0.03
P=0
P=.5
P=1
P=2

0.02
0.01
0

10

Time

Here we show the calibrated function (t) of Equation (4) for various values of p:

12

18

JumpDiffusion Vols: (t)

0.5
P=0
P=.5
P=1
P=2

0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0

10

12

Time

To see the effect of E2C on pricing, we consider a 5 year convertible bond with current stock price
9, convertible any time at a strike of 10, r=3%, d=0%, vol=50, with a 5 year default probability
of .133, equivalent to a flat CDS spread of approximately 170bps. If we look at the model price
of this bond a year in the future without E2C, we see the bond price asymptotically approaches a
flat line at the present value of the coupons discounted at the risk-adjusted rates. However, when
we add E2C, the bond floor disappears: as the stock price goes to zero, the bond price also drops
off to zero, as the credit quality deteriorates. We see this drop off using two different values (0.5
and 1.5) for the exponent parameter p.

19

Comparison of Bond Price in 1 Year High, Low and No E2C

180
160

Bond Price Per 100

140
120
100
No E2C: P=0.0
Lo E2C: P=0.5
Hi E2C: P=1.5

80
60
40
20

10

15

Stock Price in 1 Year

Delta and Gamma Calculations

Bloomberg now offers a choice of calculation methods for Delta and Gamma: users can request
either bump-and-reprice values for these sensitivities, or grid values. We explain below how the
two types are calculated, and how they differ.
Bump-and-reprice values are computed by independently repricing the bond at higher and lower
stock prices. Let S0 represent the current stock price, dS represent a shift in the stock price, and
B(S) represent the bond price computed from the model with initial stock price S. Then Delta
and Gamma can be estimated as
Delta =

Gamma =

B(S0 + dS) B(S0 dS)

2 dS

B(S0 + dS) + B(S0 dS) 2B(S0 )

(dS)2

20
Grid values are computed by using values for B(S0 dS) computed on the PDE pricing grid. These
prices are available from the PDE grid used to compute B(S0 ). Since the bond prices for shifted
stock prices come from the same PDE grid as the bond price for the original stock price, the grid
Delta and Gamma will generally be smoother and more accurate estimates than values computed
from bump-and-reprice. We therefore recommend using grid values.
Without E2C, while the two methods produce different results, they are different estimates of
the same theoretical values. But with E2C the methods are different. The bump-and-reprice
values assume the initial credit spread does not change as the stock price is bumped up and down.
Implicit in the grid values however, the credit spread is assumed to change consistently with the
E2C assumption as the stock price is shifted. Thus, the grid Delta includes a credit hedge using
stock, whereas the bump-and-reprice delta does not include a credit hedge.

Borrow Cost

Borrow cost is a fee paid to borrow stock for the purpose of shorting. This fee appears to the
stockholder as a source of income, just like a dividend. Thus, for modelling purposes, we treat the
borrow cost as a continuous dividend, that is, as an addition to the variable q(t), the instantaneous
forward continuous dividend rate. However, this increment to the dividend is not included in the
dividends used to determine conversion ratio adjustments triggered by dividend protection.

10

Computation of Expected Life

Let u(t, St ) represent the expected life of the bond, as seen from time t, stock price St , under the
risk neutral measure. Assume the stock follows the jump-diffusion process given in (2).
Consider times t and t + dt. Assume the bond has not been early-terminated up to time t, and that
jumps can only occur at times t and t + dt, with all the jump probability occurring in the interval
dt applied to the probability of a jump at t + dt. Further, assume that for each feature which might
lead to early exercise (such as puts, calls, conversion, etc.) there is a critical boundary St which
is the least/greatest price at which early exercise occurs for that feature at time t, and that this
critical price S is a continuous function of t. We will show that the probability of St crossing the
critical boundary St is o(dt).
Assume without loss of generality that St < St ; a similar argument applies for a barrier below
and let S = min(S , u (t, t + dt).
There exists some dt
such that
St . Fix a time interval dt
u

S St > 0. Then for any time increment dt < dt,

P (St+dt > St+dt

) < P (St+dt > S)

Then the probability of crossing S between times t and t + dt is given by

(7)

21

+ (r q + h 2 /2)dt
log(St /S)

dt

!
=N

log(St /S)
(r q + h 2 /2) dt

dt

This probability is o(dt).1 Combining the previous two equations, we can conclude that P (St+dt >

St+dt
) is also o(dt). By next-step analysis it then follows that
u(t, s) = dt + Et [u(t + dt, St+dt )] + o(dt)

(8)

By Itos formula for jump-diffusion processes, we have

u(t + dt, St+dt ) = u(t, S) + ut dt + uS [(r q + h)Sdt + SdW ]
+ 12 uSS 2 S 2 dt + [u(t + dt, St+dt ) u(t, s)] dUt
Taking the risk neutral expectation at time t of this equation yields
Et [u(t + dt, St+dt )] = u(t, S) + ut dt + uS (r q + h)dt + 12 uSS 2 S 2 dt+
Et ([u(t + dt, St+dt ) u(t, s)]dUt )

(9)

We now compute the expectation of the jump term, the last term in the equation above. We note
that dUt is one with probability hdt, and when it is one we have a default, so the expected life
changes from its pre-default value to zero; and when dUt is zero, the entire term is zero. Thus
Et ([u(t + dt, St+dt ) u(t, s)]dUt ) = u(t, S)h dt
Substituting this back into equation (9) yields
1
Et [u(t + dt, St+dt )] = u(t, S) + ut dt + uS (r q + h) dt + uSS 2 S 2 dt u(t, S)h dt
2
Finally, substituting this back into equation (8) yields
1
u(t, s) = dt + u(t, S) + ut dt + uS (r q + h)dt + uSS 2 S 2 dt u(t, S)hdt + o(dt)
2
Canceling the u(t, S) terms on either side and dividing by dt, and ignoring terms smaller than
order dt, we get a PDE which must be satisfied by the function u:
1
0 = 1 + ut + uS (r q + h) + uSS 2 S 2 uh
2
1
so log(St /S)
is negative. Thus, as dt goes to zero, the log term goes to negative infinity.
Note first that St < S,
The second term of the argument to the cumulative normal function goes to zero and so can be ignored. Thus
we are looking at the rate of decay of the left tail of the normal distribution, which is the same as the rate of
decay
is easy to see that this tail of the normal distribution decays exponentially. For large x,
R of the2 right tail.R It

exp(y /2)dy <= x y exp(y 2 /2)dy = exp(x2 /2).

x

22
We solve this PDE with boundary conditions at maturity u(t, S) = 0 for all S, and forcing u(t, S)
to zero on conversion, put, call, or other life-terminating event explicitly handled by a boundary
condition in the PDE.