Convertible bond status

[Joseph Wang]

I did some work in CVS to check in a PDF engine that would support the
T-F convertible bond model, but my research has taken me into a
different direction.  My goal is to understand the pricing of Shanghai
convertible bonds, and originally want I wanted to do was to use the T-F
model to calculate an implied credit risk for Shanghai bonds.  Some more
reading has put me on a different path.  Specifically there is a paper
that showed that the trading value of a CB often falls substantially
below the conversion value when the bond hasn't entered the conversion
period.  There is no way I can think of to get that result via an
implied credit risk, and right now I'm looking at some different
approaches.  My working theory is that Chinese stock prices do *not*
accurately reflect the firm value, and the mismatches in the CB values
are due to this.

I should point out that a lot of this reflects on different ways CB's
are used in China and in the West.  Western CB's are used to raise
capital for high-risk, high-reward companies so the focus is on
modelling credit and default risks.  Chinese CB's are used mainly as
stock-substitutes.  Chinese companies that issue CB's are generally big
firms with an explicit insurance against default by the CB underwriter
and an implicit insurance against default by the government.  A Western
firm in the same situation would probably issue straight debt.  A
Chinese company doesn't want to issue equity because that dilutes the
value of the non-listed shares (1/3 is typically government owned and
1/3 is typically owned by legal persons).  On the other hand, I suspect
that a Chinese company doesn't want to issue straight debt because share
prices in Shanghai are at absurd levels, and having a conversion
provision I suspect greatly reduces the cost of borrowing.

What this means for my quantlib work is that a Chinese companies issuing
a CB doesn't have much of a default risk but are much more likely to be
hitting a forced conversion or redemption provision.  So I'm interested
in modelling those using mainly monte-carlo methods.  Also, I have the
feeling that the weird capital and ownership structure of Chinese listed
companies have a big impact on the value of their convertible bonds.  
Also, I suspect that the weird capital and ownership structure might
mean that the standard "rules" for when people should exercise their
conversion options don't work.

Most of what I'm doing is geared more to long term public policy rather
than to short term arbitrage.  For example, how do you sell off the 1/3
government owned part of a company without causing the Shanghai stock
market to crash?

One impression that I do get reading the Chinese quant finance
literature is that it has a very "Russian" feel to it.  People are doing
some very clever and elegant things using analytic methods, but there is
very little heavy duty number crunching because the numerical expertise
isn't there because of historical hardware limitations.