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Coco Bonds Pricing With Credit And Equity Calibrated First-Passage Firm Value Models

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  • DAMIANO BRIGO

    (Department of Mathematics, Imperial College, South Kensington Campus, London SW7 2AZ, UK)

  • JOÃO GARCIA

    (London, UK)

  • NICOLA PEDE

    (Department of Mathematics, Imperial College, South Kensington Campus, London SW7 2AZ, UK)

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.

Suggested Citation

  • Damiano Brigo & João Garcia & Nicola Pede, 2015. "Coco Bonds Pricing With Credit And Equity Calibrated First-Passage Firm Value Models," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 18(03), pages 1-31.
    • Handle: RePEc:wsi:ijtafx:v:18:y:2015:i:03:n:s0219024915500156
    DOI: 10.1142/S0219024915500156
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    References listed on IDEAS

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    1. Damiano Brigo & Jo~ao Garcia & Nicola Pede, 2013. "CoCo Bonds Valuation with Equity- and Credit-Calibrated First Passage Structural Models," Papers 1302.6629, arXiv.org.
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    Citations

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    Cited by:

    1. Mike Derksen & Peter Spreij & Sweder Van Wijnbergen, 2022. "ACCOUNTING NOISE AND THE PRICING OF CoCos," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 25(07n08), pages 1-60, November.
    2. Francesca Biagini & Alessandro Gnoatto & Maximilian Hartel, 2015. "The Long-Term Swap Rate and a General Analysis of Long-Term Interest Rates," Papers 1507.00208, arXiv.org, revised Jun 2019.
    3. Choe, Geon Ho & Jang, Hyun Jin & Na, Young Hoon, 2019. "Pricing contingent convertible bonds: An analytical approach based on two-dimensional stochastic processes," Statistics & Probability Letters, Elsevier, vol. 148(C), pages 43-53.
    4. Delphine Boursicot & Geneviève Gauthier & Farhad Pourkalbassi, 2019. "Contingent Convertible Debt: The Impact on Equity Holders," Risks, MDPI, vol. 7(2), pages 1-35, April.
    5. Pierluigi Bologna & Arianna Miglietta & Anatoli Segura, 2020. "Contagion in the CoCos Market? A Case Study of Two Stress Events," International Journal of Central Banking, International Journal of Central Banking, vol. 16(6), pages 137-184, December.
    6. Francesca Biagini & Alessandro Gnoatto & Maximilian Härtel, 2020. "General Analysis Of Long-Term Interest Rates," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 23(01), pages 1-29, January.
    7. Chi Man Leung & Yue Kuen Kwok, 2017. "NUMERICAL PRICING OF CoCo BONDS WITH PARISIAN TRIGGER FEATURE USING THE FORTET METHOD," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 20(07), pages 1-22, November.
    8. Christian Koziol & Sebastian Weitz, 2021. "Does model complexity improve pricing accuracy? The case of CoCos," Review of Derivatives Research, Springer, vol. 24(3), pages 261-284, October.

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