Pricing and Hedging CoCos
June 14, 2013
Contingent convertible bonds are typical hybrid products in that they are exposed to different sources of risk: interest rate risk, equity risk and conversion risk. We develop a general framework for their pricing and hedging that can be specified in different ways. We focus on structural and reduced form models driven by a finite-dimensional Markov process. The two approaches are qualitatively different. But both allow to price contingent convertibles and calculate dynamic hedging strategies with holdings in related instruments such as fixed income products, the issuing company's stock and credit default swaps. As case studies we consider contingent convertibles issued by Lloyds Banking Group in December of 2009 and Rabobank in March of 2010. Both modeling approaches suggest that on Oct 14, 2011, the contingent convertibles of Lloyds Banking Group traded at a price that was low relative to market quotes of the firm's equity, interest rate swaps and credit default swaps, while they produced prices for the ones of Rabobank that were close to their market value.
Number of Pages in PDF File: 26
Keywords: Contingent convertible bonds, credit default swaps, pricing, calibration, hedging, structural model, reduced form model
JEL Classification: G12, G13working papers series
Date posted: January 17, 2013 ; Last revised: July 7, 2013
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