COCO BONDS PRICING WITH CREDIT AND EQUITY CALIBRATED FIRST-PASSAGE FIRM VALUE MODELS

Damiano Brigo, João Garcia () and Nicola Pede ()
Additional contact information
João Garcia: London, UK
Nicola Pede: Department of Mathematics, Imperial College, South Kensington Campus, London SW7 2AZ, UK

International Journal of Theoretical and Applied Finance (IJTAF), 2015, vol. 18, issue 03, 1-31

Abstract: Since the beginning of the credit and liquidity crisis, financial institutions have been considering creating a convertible-bond type contract focusing on capital. Under the terms of this contract, a bond is converted into equity if the authorities deem the institution to be under-capitalized. This paper discusses this contingent capital (CoCo) bond instrument and presents a pricing methodology based on firm value models that calibrate exactly the credit term structure of the issuer either through credit default swaps or corporate bonds data. Decorrelation between the capital conversion trigger and credit quality is introduced. The equity value for the issuer is derived in closed form with a barrier option type formula. A stress test of model parameters is illustrated to account for potential model risk and the obtained prices are compared to the price obtained from a market source. Finally, a brief overview of how the instrument valuation performs compared to pure corporate bonds and a discussion involving the CDS bond basis are presented.

Keywords: Contingent capital; CoCo bonds; AT1P model; firm value models; credit default swap calibration; conversion time; default time; hybrid credit-equity products; Basel III; systemic risk (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (8)

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DOI: 10.1142/S0219024915500156

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