The following quotes are from Mihir Bhattacharya, “Convertible Securities and Their Valuation,” Chapter 51 in Frank J. Fabozzi (ed.), The Handbook of Fixed Income Securities: Sixth Edition (New York: McGraw-Hill, 2001).
(a) Bhattacharya states:
“Increased debt market volatility has driven home the point of duration risk inherent in any security with a fixed income component, including convertibles. The increased volatility of the spreads (over Treasury or other interest rate benchmarks) has heightened investor sensitivity to the reliability of the fixed income floor or bond value of the convertible.”
What message is the author is trying to convey to investors?
(b) Bhattacharya states:
“Convertibles have equity and interest rate options, and occasionally, currency options, embedded in them. Issuers and investors are becoming even more aware that option valuation is driven by, among other factors: (a) equity volatility; (b) interest rate volatility; and (c) spread volatility. In some situations the embedded options may easily be separated and valued. However, in the vast majority of cases, they interact with other and so prove difficult, if not impossible, to separate. Investors should be aware of the inherent danger of attempting to value the embedded options as if they were separable options.”
Explain why the factors mentioned in the quote affect the value of a convertible bond and why the factors interact.