Why do firms issue convertible bonds?
… lower the exercise price, the greater the value of the option. Increased volatility of the common stock works to the advantage of the option holder. This is because the downside risk of the option is bounded at zero. Therefore, an increase in variance expands the upside potential of the option while the downside risk continues to be bounded at zero. The longer the time to expiration of the option, the more valuable it becomes. Moreover, the higher the short-term, risk-free interest rate, the greater the value of the option. Finally, the higher the dividend on the common, the lower the value of the option. There are three types of options employed by business firms in their financing – the warrant, the convertible bond and the exchangeable security. Convertible bonds are somewhat different from the rest as they represent a hybrid security – part bond or preferred stock and part common stock. …
