Pricing a convertible bond

Convertible bonds are usually issued by firms with low credit rating and high growth potential. These firms can lower their interest costs by giving the right (but with no obligation), to the bondholder to convert the bond into a specified number of shares of common stock of the issuing company. The investor receives the potential upside of conversion into equity, while having downside protection with cash flows from the bond. The company benefits from the fact that when the convertibles are converted, the leverage of the company decreases while the trade-off is the stock dilution when the bonds are converted.

These characteristics state that the convertible bonds' behavior has three different stages: in-the-money convertible bonds (conversion price < equity price) behave like equity, at-the-money (conversion price = equity price) convertible bonds are considered as equity and debt, while out-of-the money (conversion price > equity price) convertible bonds...