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Pricing and Hedging CoCos

Patrick Cheridito

Princeton University

Zhikai Xu

AQR Capital Management, LLC; Princeton University

June 14, 2013

Contingent convertible bonds are typical hybrid products in that they are exposed to diff erent sources of risk: interest rate risk, equity risk and conversion risk. We develop a general framework for their pricing and hedging that can be speci fied in diff erent ways. We focus on structural and reduced form models driven by a fi nite-dimensional Markov process. The two approaches are qualitatively diff erent. But both allow to price contingent convertibles and calculate dynamic hedging strategies with holdings in related instruments such as fi xed 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 fi rm'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, G13

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Date posted: January 17, 2013 ; Last revised: July 7, 2013

Suggested Citation

Cheridito, Patrick and Xu, Zhikai, Pricing and Hedging CoCos (June 14, 2013). Available at SSRN: http://ssrn.com/abstract=2201364 or http://dx.doi.org/10.2139/ssrn.2201364

Contact Information

Patrick Cheridito (Contact Author)
Princeton University ( email )
Princeton University
Princeton, NJ 08544
United States

Zhikai Xu
AQR Capital Management, LLC
Greenwich, CT
United States
Princeton University ( email )
22 Chambers Street
Princeton, NJ 08544
United States
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References:  27
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