Imagine a bond that can transform into stock. That is a convertible bond. Chapter 33 of Wilmott’s book dives into one of the most fascinating instruments in finance, a hybrid security that sometimes acts like debt and sometimes acts like equity. It sounds simple on the surface, but underneath it is a deeply complex contract involving American option features, stochastic interest rates, path dependence, dilution, and credit risk.
With Chapter 30, we enter Part Three of the book: fixed-income modeling and derivatives. Up to now, interest rates have been either constant or known functions of time. That is fine for short-dated equity options. But for longer-dated contracts, and especially for bonds and interest rate derivatives, we need to treat the interest rate itself as random. This changes everything.
This is Part 1 of our retelling of Chapter 2 from “Trading the Fixed Income, Inflation and Credit Markets: A Relative Value Guide” by Neil C. Schofield and Troy Bowler (Wiley, 2011, ISBN: 978-0-470-74229-7).