Pricing Contingent Convertible Bonds - An Empirical Approach

Sasa Popovic and Ana Mugosa
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Sasa Popovic: University of Montenegro, School of Economics, Montenegro
Ana Mugosa: University of Montenegro, School of Economics, Montenegro

from University of Primorska Press

Abstract: This article provides analysis of structuring and pricing models for contingent convertible (CoCo) bonds. Financial instability at the beginning of XXI century forced governments to make serious efforts in order to protect financial sector from consequences of future financial crisis. One of these efforts resulted in creating new regulatory framework for bank capital adequacy. In that context a special type of bonds, so-called Contingent Convertibles (CoCo) have become popular in a banking sector. The characteristic of this debt instrument is the possibility to convert into equity, or to be written off, due to the certain trigger event. In that order bonds convert to equity during financial distress. Therefore, the aim of this paper is to analyse the empirical validation of two different CoCo pricing models, equity derivatives model (EDM) and credit derivatives model (CDM), as well as to conduct their comparative analysis. The models are applied on the CoCo’s issued by The Credit Suisse Group AG bond, on the 18th June 2014 with a volume of 2.5 billion USD. This issue has perpetual maturity, mechanical capital trigger, and loss absorption mechanism is permanent principal write-down. The Black-Scholes methodology was used to price the CoCo’s in EDM and CDM. The results show approximately the same trigger level, 3.95 CHF for CDM and 4.37 CHF for EDM, which contributes to the reliability of models applied. This paper contributes to academic literature on complex convertible financial instrument such as CoCo bond by employing empirical approach to selected pricing models. Although some academics and practitioners address many criticisms against CoCo’s, it is evident that these instruments record high volume of issuance and attract lot of professional attention. Black-Scholes model is widely employed in estimation of CoCo bonds price, but recent empirical evidence demonstrates that the basic model assumption of constant volatility is not reasonable, as these instruments carry a lot of fattail risk. Therefore, our future research will be extended to appliance of more calibrated models, meaning simulation based models.

Keywords: contingent convertible bonds; CoCo, trigger event; loss absorption mechanism (search for similar items in EconPapers)
Date: 2017
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Persistent link: https://EconPapers.repec.org/RePEc:prp:micp17:251-261

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