Implementing a Trinomial Convertible Bond Pricing Model

Stuart McCrary discusses a model to create a trinomial stock price tree with mean reversion to price convertible bonds and convertible preferred stock.

This manuscript documents a model to value convertible bonds and preferred stock subject to default. The model is based significantly on a published model that relies on a trinomial stock tree.

This document describes particulars used to implement a tree-based model to value convertible bonds, based in part on the model described by John Hull in Futures, Options, and Other Derivatives. The model presented will implement a similar model, except the user has much more flexibility to input key assumptions for interest rates, default probabilities, and volatilities over time. The model presented will rely on a tree that captures the cash-flow patterns typical of common stocks, which may affect the value of early conversion.