For example, a start-up could have a project that would require a significant amount of capital, resulting in a short-term loss of revenue. However, the project is expected to drive the company to profitability in the future. Investors in convertible bonds can recoup some of their capital after the company has failed, while they can also benefit from capital valuation by converting bonds into equity if the business succeeds. Mandatory convertible bonds must be converted by the investor into a defined change report and price level. On the other hand, a reversible convertible loan gives the company the right to convert the bond into shares or to keep the bond as a fixed-rate investment until maturity. When the loan is converted, it is a pre-defined price and change ratio. The global convertible bond market is relatively small (approximately $400 billion in January 2013 without synthesis) and the direct corporate bond market is estimated to be about $14 trillion. Of this $400 billion, there are approximately $320 billion of vanilla convertible bonds, the largest sub-segment in the asset class. Since 1991/92, most market-makers in Europe have used binomial models to evaluate convertibles. Models were available from INSEAD, trend data from Canada, Bloomberg LP and models developed by themselves, among others. These models required credit spread entry, price-fixing volatility (commonly used historical volatility) and risk-free returns. The binomial calculation assumes that there is a bell-shaped probability distribution on future stock prices, and the higher the volatility, the flatter the bell shape. If there are calls from issuers and investor coupons, these will influence the expected residual life of the choice at different levels of stock prices.

The binomial value is a weighted expected value, (1) taking into account the values measured from all the nodes in a grid that ranges from current prices and (2) taking into account the different periods of the expected residual option at different levels of stock prices. See Lattice model (Finance) #Hybrid Securities. The three main areas of subjectivity are (1) the volatility rate used, as volatility is not constant, and (2) whether or not they incorporate the cost of equity loans for hedge funds and market makers into the model. The third important factor is (3) the status of dividends of equity issued when the bond is called, since the issuer can account for the invitation to minimize the cost of dividends for the issuer. Convertible bonds are most often issued by companies with low credit ratings and high growth potential. Convertible bonds are also considered bonds because companies agree to set fixed or fluctuating interest rates, as is the case with bonds common to investors` funds. To offset the additional value by the option to convert the bond into shares, a convertible loan generally has a lower coupon rate than similar non-convertible debt securities. The investor benefits from the potential benefit of converting to equity, while protecting the disadvantage of cash flow generated by coupon payments and return on capital at maturity. These characteristics – and the fact that convertible bonds often act below fair value[3] – naturally lead to the idea of convertible arbitrage, where a long position in the convertible bond is offset by a short position in the underlying equity.