Valuation Model of Chinese Convertible Bonds Based on Monte Carlo Simulation

Abstract

We address the problem of pricing Chinese convertible bonds(CCB) by Monte Carlo simulation and dynamic programming. At each exercising time, we use the state variables of the underlying stock to regress the continuation value, and then we apply standard backward induction to get the coefficients until the moment of time zero, thus the price of the CCB is obtained. We apply the pricing of CCBs by simulation and test the performance of an under-priced strategy: long the 10 most underpriced CCBs and rebalance daily. The result show this strategy significantly outperforms the double-low strategy which is used as a benchmark. In practice, CCB issuers usually use the downward adjustment clause to to avoid financial distress upon put provision. Therefore, we treat the downward adjustment clause as a probabilistic event triggering the put provision. In this way, we combine the downward adjustment clause with put provision in a simple manner.