CoCo Bonds and Implied CET1 Volatility
27 Pages Posted: 10 Mar 2015 Last revised: 18 Dec 2015
Date Written: December 18, 2015
In this work we introduce the notion of implied Core Equity Tier 1 volatility and the concept of a risk-adjusted distance to trigger. Using a derivatives-based valuation approach, we are able to derive the implied CET1 volatility from the market price of a CoCo bond in a Black-Scholes setting. The numerical results in this paper show how different contingent convertibles issued by the same bank and sharing a similar contractual CET1 trigger, have almost identical implied CET1 volatility levels. The same results confirm the difference in market risk between Tier 2 and Additional Tier 1 CoCo bonds. The ability to obtain an implied level for the CET1 volatility offers other interesting results. We are able to determine the implied CET1 level corresponding to a coupon cancellation. It further allowed us for example to look at the severity of one of the stress tests imposed by the ECB on European banks in November 2014. In that perspective we were also able to derive implied PONV CET1 levels.
Keywords: contingent convertibles, CoCo bonds, CET1, Core Equity Tier 1, PONV, Point of Non-Viability
JEL Classification: G12, G13, G18, G21, G28, G32
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