Valuation of Reverse Convertibles in the VG Economy

Prior research on structured products has demonstrated that equity-linked notes sold to retail investors in initial public off erings are typically issued at above their fair market value. A particular type of equity-linked note { reverse convertibles { embed down-and-in put options and o er investors relatively high coupon payments in exchange for bearing some of the downside risk of the equity underlying the note. We analytically study the magnitude of the overpricing of reverse convertibles - one of the most popular structured products on the market today - within a stochastic volatility model.

We extend the current literature to include analytical valuation formulas within a model of stochastic volatility - the Variance Gamma (VG) model. We show that these complex notes are even more overpriced than previously estimated when stochastic volatility is taken into account. As a result of their complex payout s and the lack of a secondary market to correct the mispricing, reverse convertible notes continue to be sold at prices substantially in excess of their fair market value.

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Craig J. McCann