Is the Jump-Diffusion Model a Good Solution for Credit Risk Modeling? The Case of Convertible Bonds

This paper presents a new framework that relies on the probability distribution of a default jump rather than the default jump itself. As such, the model can back out the market prices of convertible bonds. The empirical results show that the model prices fluctuate randomly around the market prices, indicating the model is quite accurate. Our empirical evidence does not support a systematic underpricing hypothesis. Moreover, market participants almost always calibrate their models to the observed market prices using implied convertible volatilities. Therefore, underpricing may not be the main driver of profitability in convertible arbitrage.