Ralf Seiz

Pricing and Hedging Mandatory Convertible Bonds

Both investors and corporations find some features of equities attractive and others less desirable. The same can be said for bonds, so it is no surprise that a broad range of hybrid derivatives, partly equity-like and partly bond-like, have been created that offer different blends of the preferred aspects of the two. This article looks at mandatory convertibles, about the most equity-like of these instruments. A mandatory convertible pays regular coupon interest for the first part of its life, and then it converts into shares of the firms stock. The conversion ratio is a function of the terminal stock price, such that there is equity participation on both the upside and the downside, but a bond-like fixed dollar payoff in the middle range. The payoff can be replicated with a long position in plain vanilla bonds and an option spread on the equity. In empirical tests, the valuation model fits well, better than is typical in studies of ordinary convertibles. High coupons and high dividends are favored by the market, i.e., they are associated with overpricing, while longer maturities, high stock price relative to the option strikes and wider credit spreads are associated with underpricing in the market.

Demographic Change and Pharmaceuticals' Stock Returns

We analyse how demographic change affected profits and returns across pharmaceutical industries over the last 20 years. Fluctuations in different age group sizes influence the estimated demand changes for age‐sensitive drugs, such as antibacterials for young, antidepressants for middle‐aged, and antithrombotics for old people. These demand changes are predictable as soon as a specific age group is born. We use consumption and demographic data to forecast future consumption demand growth for drugs caused by demographic changes in the age structure. We find that long‐term forecast demand changes predict abnormal annual pharmaceutical stock returns for more than 60 firms over the time period from 1986 to 2008. An increase by one percentage point of annual demand growth due to demographic changes predicts an increase in abnormal yearly stock returns in the size of 3–5 percentage points. Short‐term forecast demand changes does predict negative abnormal stock returns for a time horizon below 5 years. A trading strategy taking advantage of the demographic information earns a significant abnormal return between 6 and 8 percentage points per year. Our results are consistent with the model by DellaVigna and Pollet (2007), where investors are inattentive with extrapolation in the distant future and overreact to information in the near future.