Decomposing and valuing convertible bonds: A new method based on exotic options

We use exotic options to develop a complete decomposition method for analyzing callable convertible bonds (CCBs), and puttable callable convertible bonds (PCCBs) with credit risk. Since exotic options are path-dependent while vanilla options are not, exotic options can better address the risk exposure, and better replicate the payoff features of CCBs and PCCBs embedded with path-dependent options, than do vanilla options or warrants used by previous decomposition methods. Our method provides investors with an effective tool to analyze the effects and interactions of the different provisions contained in CCBs and PCCBs. This provides better insight into the valuation and analysis of CCBs and PCCBs. •We use exotic options to develop an equivalent decomposition method for valuing PCCBs with credit risk.•We take into account the interactions between the embedded options in the PCCB and provide more accurate pricing formulae.•Our pricing formulae show both intuitively and explicitly the value of each embedded feature in the PCCB.