Contingent Conversion Convertible Bond: New Avenue to Raise Bank Capital
22 Pages Posted: 5 Jan 2013
Date Written: October 31, 2012
This paper provides an in-depth analysis into the structuring and the pricing of an innovative financial market product. This instrument is called contingent conversion convertible bond or "CoCoCo". This hybrid bond is itself a combination of two other hybrid instruments: a contingent convertible ("CoCo") and a convertible bond. This combination introduces more complexity in the structure but it now allows investors to profit from strong share price performances.
This upside potential is added on top of the normal contingent convertible mechanics whereas CoCos only expose the investors to downside risk. This sets up a new avenue for the banks to create new capital.
First, we explain how the features of the contingent convertible bonds on one side and the features of the standard convertible bonds on the other side are combined. Thereafter, we propose a pricing approach which moves away from the standard Black & Scholes setting. The CoCoCos are evaluated using the Heston process to which a Hull-White interest rate process has been added. We demonstrate the importance of using a stochastic interest rate when modeling this instrument. Finally we quantify the loss absorbing capacity of this instrument.
Keywords: G13, G18, G21, C15
JEL Classification: Convertible bonds, Contingent convertible bonds, Monte Carlo simulations, Sensitivity analysis
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