Extending the LYONs Pricing Model

The Liquid Yield Option Note (LYON), created by Merrill Lynch, is a highly successful financial innovation. LYON is a zero-coupon, callable, putable and convertible bond. None of the features of a LYON is new. It is their combination which appeals to investors and issuers. The McConnell and Schwartz (1986) model was the first to address the issue of pricing LYONs. Besides other assumptions, the model assumes that the LYON can be converted into common stock unconditionally, and no interest is paid on these bonds. However, for many LYONs trading today, their convertibility into common stock is conditional upon the issuer’s stock price crossing certain prescribed thresholds during certain periods of time. Also, many LYONs pay interest, contingent upon the price of the LYON again crossing certain prescribed thresholds. The McConnell and Schwartz (1986) pricing model does not address these issues. We extend the original model to take into account the issues of conditional convertibility and contingent interest. Also, we incorporate the default risk of the issuer in the model differently from how it was done in the McConnell and Schwartz (1986) model