Pricing Contingent Convertibles: A Derivatives Approach

Abstract

This article provides an in-depth analysis of pricing and structuring 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. Equity is in this case injected on the very moment the bank is failing to meet the minimum regulatory capital requirements or when it is heading towards a state of non-viability. In this paper the pricing of CoCos is handled using two different approaches. The first approach starts from a credit derivatives background. A second approach tackles the pricing and structuring of a CoCo as an equity derivatives problem. Both models are applied on the CoCos issued by Lloyds and Credit Suisse and allow to quantify the risks embedded within each of these structures.

Keywords: CoCos, Contingent, Capital, Derivatives

JEL Classification: G12, G13, G18, G21, G28, G32