Premium
Exploring the difference between implied volatilities of options embedded in convertible bonds and exchange‐traded options and its contributing factors
Author(s) -
SaeSue Tanawit,
Sinthawat Supawut,
Srivisal Narapong
Publication year - 2020
Publication title -
journal of corporate accounting and finance
Language(s) - English
Resource type - Journals
eISSN - 1097-0053
pISSN - 1044-8136
DOI - 10.1002/jcaf.22429
Subject(s) - convertible bond , capitalization , bond , arbitrage , equity (law) , financial economics , convertible arbitrage , market capitalization , business , volatility (finance) , monetary economics , debt , corporate bond , stock exchange , economics , finance , stock market , risk arbitrage , capital asset pricing model , paleontology , linguistics , philosophy , horse , arbitrage pricing theory , political science , law , biology
The convertible feature attached to a newly issued bond represents an embedded option whose value is determined by firm. The embedded option's implied volatility reflects the firm's view of its stock price risk which may differ from that of the market reflected in the exchange‐traded option. If such a gap in implied volatilities exists, it may create arbitrage opportunity for investors. Hence, we determined the gap between the implied volatilities extracted from the U.S. exchange‐traded option and embedded option and investigated its potential contributing factors, including corporate variables (price‐to‐book, market capitalization, cost of debt, debt‐to‐equity) and bond variables (maturity, default probability). The result showed that, during 2014–2016, the difference existed and was attributed to the firm's market capitalization. Our finding suggests the potential arbitrage opportunity in the debt, equity, and convertible instruments of small market capitalization firms.