The valuation of contingent convertible catastrophe debt under simple solvency and liquidity covenants

Nick Georgiopoulos

Journal of Risk

Abstract: ABSTRACT We study a new bond-like security that is a write-off debt instrument whose writeoff is triggered by solvency and event-driven covenants. This instrument is called a contingent convertible catastrophe (CoCoCAT) bond. To price it, we employ a contingent-claims-valuation approach by jointly valuing all corporate securities of the issuing firm and we derive the write-off and default policies for the CoCoCAT investors and the equity holders, respectively. We find that under simple solvency covenants the issuer finds it optimal to lever 100% with CoCoCAT debt to extract tax shields. We also find that simple liquidity covenants can explain why issuers do not issue too much debt: liquidity may be more valuable than tax shields. We analyze the security using both a diffusion process and a jump-diffusion process for the claims.

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