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How to Price Convertible Bonds and Why They Are Issued

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Convertible bonds hybrid instruments which have both debt and equity characteristics. Like straight bonds, convertible bonds are entitled to receive coupons and principal payments. However, the holders of convertible bonds have the option to forgo these cash flows by converting their bonds into a pre-specified number of shares. To price convertible bonds, it is therefore critical to characterize this option. This article will show that, in their simplest form, convertible bonds can be decomposed into a straight bond and a warrant component. Pricing is then a matter of pricing the individual components and adding up. The article then will turn to discussing the <<delayed equity>> and <<sweetening debt>> rationales for issuing convertibles.

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Convertible Bonds, Pricing



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