Contingent Convertible (CoCo) Bonds: A First Empirical Assessment of Selected Pricing Models

Sascha Wilkens and Nastja Bethke

Financial Analysts Journal, 2014, vol. 70, issue 2, 59-77

Abstract: This study is the first to assess selected pricing models for contingent convertible (CoCo) bonds empirically. Substantial amounts of these instruments have recently been issued by a number of banks. The authors’ analysis shows that although all tested approaches—a structural model, an equity derivatives model, and a credit derivatives model—largely fit market prices, they exhibit biases in derived hedge ratios. The equity derivatives model is the most practical for the pricing and risk management of CoCo bonds.With several banks issuing substantial amounts of contingent convertible (CoCo) bonds since 2009, this article is the first to analyze empirically the suitability of selected pricing models proposed for this kind of instrument. To the best of our knowledge, no comprehensive empirical analysis of the pricing of CoCo bonds has been conducted until now. Neither a “market standard” nor a preferred practitioner approach for the pricing and hedging of CoCo bonds exists at this point. This article aims to close this research gap by comparing the performance of three types of pricing models—a structural model, an equity derivatives model, and a credit derivatives model—with respect to reconciling and explaining market prices and their changes over time for the major CoCo bond issues by Lloyds Banking Group and Credit Suisse (some of the earliest examples).The “classic” CoCo bond is a debt instrument that converts into common equity when the issuing financial institution’s capital ratio falls below a predetermined critical level. It is therefore not surprising that we found the underlying share price of the company to be one of the major price drivers of the analyzed CoCo bonds, whereas the role of other parameters, such as CDS spreads and interest rates (which are usually price drivers of vanilla bonds), in the price-building mechanism is less pronounced. Our analysis shows that all tested approaches are largely able to fit observed CoCo bond prices. Regarding the derivation of hedge ratios, however, all models are found to exhibit biases. Although the structural model’s strength lies in the explicit modeling of the bank’s balance sheet structure—reflecting all parameters required for CoCo bond pricing, such as the capital ratio trigger—this explicit modeling of the bank’s assets and liabilities also introduces significant parameter uncertainty. Essentially none of the model parameters are directly observable in the market on a daily basis, the most critical being asset value, and so approximations are necessary, which negatively affect model performance. Although the overall model specification is conceptually sound for the equity and credit derivatives models, the “reduced-form” parameterization does not capture the capital ratio trigger explicitly, which is a limitation. Nevertheless, on balance, our results point to the equity derivatives model, with its straightforward parameterization and interpretation, as the most promising approach for the practical pricing and risk management of CoCo bonds. Given that share price has been identified as one of the few clear drivers of CoCo bond prices, explicit pricing based on this parameter and the associated easy interpretation and implementation of hedging strategies are advantages from a practitioner’s viewpoint. With the limited set of bonds and time series available for our analysis, more empirical research into this young market is needed.Authors’ Note: The views expressed in this article are those of the authors and do not necessarily reflect the views and policies of BNP Paribas.

Date: 2014
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DOI: 10.2469/faj.v70.n2.3

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