Convertible Notes – Most often issued by companies with a low credit rating and high growth potential

Convertible note or convertible debt or convertible bond (or a convertible debenture if it has a maturity of greater than 10 years) is a type of bond issued by a company to a holder. The holder can convert into a specified number of shares of common stock of the issuing company or cash of equal value. It is a hybrid security with debt- and equity-like features.

The valuation challenge is to determine is the right current price today for an expected future payoff. The binomial model uses a discrete-time (lattice based) model of the varying price over time of the underlying financial instrument. Convertible bonds are most often issued by companies with a low credit rating and high growth potential

The Binomial Options Pricing model (BOPM) approach is widely used since it is able to handle a variety of conditions for which other models cannot easily be applied. This is largely because the BOPM is based on the description of an underlying instrument over a period of time rather than a single point.

The binomial pricing model uses the option’s key underlying variables in discrete-time. This is done by means of a binomial lattice (tree), for a number of time steps between the valuation and expiration dates. Each node in the lattice represents a possible price of the underlying at a given point in time.

A valuation is performed iteratively, starting at each of the final nodes (those that may be reached at the time of expiration), and then working backwards through the tree towards the first node (valuation date). The value computed at each stage is the value of the option at that point in time.

1. price tree generation,
2. calculation of option value at each final node,
3. sequential calculation of the option value at each preceding note.
4. price tree generation,
5. calculation of option value at each final node,
6. sequential calculation of the option value at each preceding node.

The valuation challenge is to determine is the right current price today for an expected future payoff. The binomial model uses a discrete-time (lattice based) model of the varying price over time of the underlying financial instrument.

The Binomial Options Pricing model (BOPM) approach is widely used since it is able to handle a variety of conditions for which other models cannot easily be applied. This is largely because the BOPM is based on the description of an underlying instrument over a period of time rather than a single point.

The binomial pricing model uses the option’s key underlying variables in discrete-time. This is done by means of a binomial lattice (tree), for a number of time steps between the valuation and expiration dates. Each node in the lattice represents a possible price of the underlying at a given point in time.

What to expect:

Valuation is performed iteratively, starting at each of the final nodes (those that may be reached at the time of expiration), and then working backwards through the tree towards the first node (valuation date). The value computed at each stage is the value of the option at that point in time.