Determining Conversion Price and Risk Premium in Cocos

George von Furstenberg

Chapter 10 in Contingent Convertibles [CoCos]:A Potent Instrument for Financial Reform, 2014, pp 103-119 from World Scientific Publishing Co. Pte. Ltd.

Abstract: The most critical variables for pricing the conversion risk premium in cocos are (i) the probability of conversion [π] in each year over the term of the bond and (ii) the recovery rate [ρ] obtained from the market value of the common equity received at conversion in relation to the face value of the bond cancelled at that time. To simplify the exposition, both π and ρ are taken to be constant over the term of the bond whose face value is normalized at 1. This principal amount will be repaid if the coco has not been converted into common stock by its maturity date [T]. The probability of the debt surviving to that date is (1 – π)T. The ‘riskless’ rate r * that functions as the discount rate is deemed to be free of credit risk. It is entered as either 3% or 6% in the implicit basic equation for R below if the term to maturity is 5 years, and as either 4% or 7% if that term is 10 years. R is the annual rate of return required on cocos under risk neutrality, meaning it does not include a premium to compensate for risk aversion but only for losses expected in the event of conversion…

Keywords: Contingent Convertibles; CoCos; Financial Reform; Financial Crisis; Risk Management; Bank Capital; Financial Services; Fixed-Income Securities; Basel III (search for similar items in EconPapers)
Date: 2014
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