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

12 Pricing Contingent Debt

12.1 INTRODUCTION

In Chapter 3 we worked out an in-depth analysis of the anatomy of contingent convertibles (CoCos). These debt instruments convert into the equity of the issuing bank or suffer a write-down of the face value upon the appearance of a trigger event. This trigger mechanism provides an automatic strengthening of the capital structure of the bank. In this chapter the pricing of CoCos is handled from two different angles. Both methods can be considered practitioners’ approaches and are directly applicable for a trading desk because they are based on observable market inputs. The first method has a credit derivatives background. The other approach puts CoCos in an equity derivatives framework. Both approaches were introduced in [69] and [70].

An equity derivatives specialist looks at this security as a potential long position in shares. A long position which is “knocked in” once a trigger event materializes. At the same moment the remaining coupon stream is wiped out. This is somehow different from a reverse convertible where a conversion into shares is only possible at maturity and not before.

A third alternative pricing model is a structural model. Under the structural philosophy based on, for example, the work of Robert Merton [149], one needs to model the assets on the balance sheet. This means that the development of a stochastic process for these assets is needed. Because the contingent convertible bonds have their conversion depending ...