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Then we show how the Das and Sundaram model can be extended to price convertible bonds which have a peculiar conversion feature; these bonds are convertible not into the stock of the bond issuer, but into the stock of a different company. We also test the empirical performance of this extended model.
This thesis is a collection of three papers that have the valuation of derivative securities as a common theme. The first paper empirically compares three convertible bond valuation models. We use an innovative approach where all model parameters are estimated by the Marquardt (1963) algorithm using a subsample of convertible bond prices. The model parameters are then used for out-of-sample forecasts of convertible bond prices. The mean absolute deviation, which is calculated as the absolute difference between the model and the market price and expressed as a percentage of the market price, is 1.70% for the Ayache-Forsyth-Vetzal (2003) model, 1.74% for the Tsiveriotis-Fernandes (1998) model, and 2.12% for the Brennan-Schwartz (1980) model. For this and other measures of fit, the Ayache-Forsyth-Vetzal and the Tsiveriotis-Fernandes models outperform the Brennan-Schwartz model. The second paper examines the market memory effect in convertible bond markets. More specifically, we look at the pricing of convertible bonds issued after the original issuer adversely redeemed previous issues without giving an opportunity for investors to benefit from bond value appreciation. We find evidence that the market underprices new convertible bond issues of firms that call their bonds early. We also find that the degree of market underpricing depends on whether the convertibles are more debt- or equity-like. In the third paper, the European put-call parity condition is used to estimate the early exercise premium for American currency options traded on the Philadelphia Stock Exchange. Using a sample of 331 pairs of call and put options with the same exercise price and time to expiration, we find that the early exercise premium on average is 5.03% for put options and 4.60% for call options. The premia for both call and put options are strongly related to the interest rate differential and time to expiration. These results are important to consider when valuing American currency options using European option pricing models.
The first essay, "Why do firms issue convertible securities? New evidence on sequential financing" investigates the sequential-financing hypothesis on the use of convertible securities (Schultz, 1993a; Mayers, 1998). Examination of conversion-forcing calls of warrants reveals significant increases in investment and financing activity for the calling firms around the time of the call. While evidence of investment and financing increases subsequent to the call is consistent with the hypothesis, there is also evidence of increases prior to the call. Furthermore, the call signals a subsequent decline in firm performance. Calling firms experience significantly higher sales growth than industry medians prior to year of the call but become indistinguishable from them subsequent to the call. Similar findings have been reported for calls of convertible debt. Multivariate analysis does not provide evidence that investment growth in the year of the call is related to existing investment opportunities, controlling for call proceeds. Overall, our findings raise questions on the validity of the sequential-financing hypothesis. The second essay, "Corporate investment, market value, and book-to-market: An empirical investigation," examines the association between market value, book-to-market (B/M), and corporate investment. Firms assigned to big and low-B/M (B/L) portfolios significantly increase investment prior to the portfolio formation year. Their market values rise and their leverage levels diminish. Small and high-B/M (S/H) firms reduce investment and increase their market leverage. When we form portfolios based on investment growth (i.e., exercise of investment opportunities), average returns are significantly lower for high investment stocks. Within investment growth groups, there is weak evidence of a value premium. Furthermore, corporate investment growth is highly significant in cross-sectional and time-series regressions and contains information similar to that of B/M. This evidence is consistent with the model of Berk, Green, and Naik (1999), who relate exercise of growth options to firm-specific fundamentals and observed returns.
The factors affecting the decision to issue different hybrid securities are tested for the UK market. Support is found only for the sweetened debt theory and not found for the delayed equity or moral hazard theories for convertible debt. Weak support is found for the financial distress and taxation theories for preference shares. I conjecture this is due to the different taxation rates and bankruptcy codes between the US and the UK. Also companies are found to resort to any form of preference share financing when ordinary shares are undervalued. Unlike previous UK studies, hybrid security issuers are found to be significantly smaller than debt issuers.