The valuation of inflation-indexed and FX convertible bonds

Abstract

This paper derives a valuation model of inflation-indexed convertible bonds that incorporates the firm's stock price, inflation indexing and the firm's credit risk. The pricing of inflation-indexed convertible bonds traded on the Tel-Aviv Stock Exchange (TASE) was empirically tested by using a comprehensive database. The study is the first to empirically test the pricing of convertibles in emerging markets. It was found that the theoretical values for the bonds are, on average, 1.94% higher than the observed market prices. Unlike previous studies, it was found that the underpricing increases with the moneyness of the convertible. It was found that as the maturity lengthens, the underpricing increases. © 2008 Wiley Periodicals, Inc.