An empirical analysis of the pricing of knock-in reverse exchangeable securities

This paper studies the pricing of knock-in reverse exchangeable securities (RES). They are securities that are initially issued as straight bonds paying regular coupons. During the life of the securities, if prices of underlying stocks hit pre-determined triggers, the securities will be knocked in, which gives issuers options at maturity date to either redeem the securities in cash, or to deliver a per-specified number of shares. In this paper, the payoffs of RES are initially replicated with bonds and options, and then building block approach is used to value each compon ent. It is thereby possible to estimate theoretically "fair" terms of issuance, and contrast these with effective terms. A significant overpricing of 5.48% is found if knock-in features are artificially removed, but if the features are added back, an underpricing of -1.98% is observed, which shows that the knock-in feature of the securities is significantly undervalued by issuers.