Risk Synergy

Another argument for convertible bonds and bonds with warrants is that they are useful when it is very costly to assess the risk of the issuing company. Suppose you are evaluating

9E. F. Brigham, "An Analysis of Convertible Debentures," Journal of Finance 21 (1966).

10W. H. Mikkelson, "Convertible Calls and Security Returns," Journal of Financial Economics 9 (September

Questions

Ross-Westerfield-Jaffe: Corporate Finance, Sixth Edition

VI. Options, Futures, and Corporate Finance

24. Warrants and Convertibles

© The McGraw-H Companies, 2002

Part VI Options, Futures, and Corporate Finance

■ TABLE 24.3 A Hypothetical Case of the Yields on Convertible Bonds*

Firm Risk

Low

High

Straight bond yield

10%

15%

Convertible bond yield

6

7

*The yields on straight bonds reflect the risk of default. The yields on convertibles are not sensitive to default risk.

*The yields on straight bonds reflect the risk of default. The yields on convertibles are not sensitive to default risk.

a new product by a start-up company. The new product is a biogenetic virus that may increase the yields of corn crops in northern climates. It may also cause cancer. This type of product is difficult to value properly. Thus, the risk of the company is very hard to determine: it may be high, or it may be low. If you could be sure the risk of the company was high, you would price the bonds for a high yield, say 15 percent. If it was low, you would price them at a lower yield, say 10 percent.

Convertible bonds and bonds with warrants can protect somewhat against mistakes of risk evaluation. Convertible bonds and bonds with warrants have two components: straight bonds and call options on the company's underlying stock. If the company turns out to be a low-risk company, the straight bond component will have high value and the call option will have low value. However, if the company turns out to be a high-risk company, the straight bond component will have low value and the call option will have high value. This is illustrated in Table 24.3.

However, although risk has effects on value that cancel each other out in convertibles and bonds with warrants, the market and the buyer nevertheless must make an assessment of the firm's potential to value securities, and it is not clear that the effort involved is that much less than is required for a straight bond.

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