Perpetual convertible bonds with credit risk

A convertible bond is a security that the holder can convert into a specified number of underlying shares. We enrich the standard model by introducing some default risk of the issuer. Once default has occured payments stop immediately. In the context of a reduced form model with infinite time horizon driven by a Brownian motion, analytical formulae for the no-arbitrage price of this American contingent claim are obtained and characterized in terms of solutions of free boundary problems. It turns out that the default risk changes the structure of the optimal stopping strategy essentially. Especially, the continuation region may become a disconnected subset of the state space....