The Handbook of Hybrid Securities: Convertible Bonds, CoCo Bonds and Bail-In

6 Modeling Hybrids: An Introduction

6.1 INTRODUCTION

It is in our human nature to try to understand how things work. Looking back at our ancestors, we see that they were driven by the same desire to know and understand more. The Greeks modeled the cosmos as a set of spheres. The planet earth was in the center of everything. It took more than 2000 years to cancel out the geocentric model and describe the mechanics of the planets orbiting around the sun. But even when the earlier models were dead wrong, they brought comfort because they helped to understand events such as the seasons, day and night, and the appearance of the stars in the sky. In finance we try to achieve the same thing, building a mathematical description – the model – of the way asset prices move. Even after incorporating the more advanced mathematical tools, every model remains unfortunately a weak blueprint of reality. The mathematical nature of the models makes us forget that they rely on assumptions about human behavior, a large difference from the laws of physics. No financial model – however sophisticated it might be – can predict the markets with certainty [40]. One never should bet the firm on it.

In this chapter we offer an introduction to the different approaches when it comes to developing a valuation model for a hybrid security. There is unfortunately no “one-size-fits-all” solution available and it should not be a surprise that each investment bank has a particular view on how to model these complex ...