Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/200122 
Authors: 
Year of Publication: 
2015
Citation: 
[Journal:] International Journal of Financial Markets and Derivatives [ISSN:] 1756-7149 [Volume:] 4 [Issue:] 1 [Publisher:] Inderscience [Place:] Olney, Bucks [Year:] 2015 [Pages:] 1-25
Publisher: 
Inderscience, Olney, Bucks
Abstract: 
This paper argues that the reduced-form jump diffusion model may not be appropriate for credit risk modeling. To correctly value hybrid defaultable financial instruments, e.g., convertible bonds, we present a new framework that relies on the probability distribution of a default jump rather than the default jump itself, as the default jump is usually inaccessible. As such, the model can back out the market prices of convertible bonds. A prevailing belief in the market is that convertible arbitrage is mainly due to convertible underpricing. Empirically, however, we do not find evidence supporting the underpricing hypothesis. Instead, we find that convertibles have relatively large positive gammas. As a typical convertible arbitrage strategy employs delta-neutral hedging, a large positive gamma can make the portfolio highly profitable, especially for a large movement in the underlying stock price.
Subjects: 
jump diffusion
convertible bond
convertible underpricing
convertible arbitrage
default time approach
default probability approach
asset pricing
credit risk modeling
Published Version’s DOI: 
Document Type: 
Article
Document Version: 
Accepted Manuscript (Postprint)
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