Two-Factor Tree Model for Pricing Convertible Bonds with Default Risk
Date Issued
2008
Date
2008
Author(s)
Kuo, Hsiang-Yu
Abstract
Our research tries to improve the convertible bond pricing model proposed by Donald R Chambers & Qin Lu (2007). They considered equity and interest rate risk using the Cox-Ross-Rubinstein (CRR) equity tree and Ho-Lee interest rate tree, and also modeled default risk in the manner of Jarrow and Turnbull (1995). They finally combined the equity tree and interest tree tree by taking their correlation into account and therefore constructed a two-factor multinomial tree model. We extend their model to account for the empirical relationship between equity price and default intensity. The intensity function introduced by Takahashi, Kobayashi, and Nakagawa (2001) is applied in our framework to match this fact. We further provide sensitivity analyses on how the assumed parameters affect the valuation of convertible bonds. At last, we use the model to price the convertible bonds issued in Taiwan market in 2006. Comparing the results with Lee (2006), we moderately reduced the relative error from 0.2115 to 0.1779.
Subjects
convertible bonds
credit risk
Type
thesis
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