Abstract
AbstractThe 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.
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