Pricing Sovereign Contingent Convertible Debt
The Wharton Financial Institutions Center WP 16-05
32 Pages Posted: 25 Jul 2016 Last revised: 17 Apr 2018
Date Written: November 2017
We develop a pricing model for sovereign contingent convertible bonds (S-CoCo) with payment standstills triggered by a sovereign's credit default swap CDS spread. One innovation is the modeling of CDS spread regime switching which is prevalent during crises. Regime switching is modeled as a hidden Markov process and is integrated with a stochastic process of spread levels to obtain S-CoCo prices through simulation. The paper goes a step further and uses the pricing model in a Longstaff-Schwartz. American option pricing framework to compute state contingent S-CoCo prices at some risk horizon, thus facilitating risk management. Dual trigger pricing is also discussed using the idiosyncratic CDS spread for the sovereign debt together with a broad market index. Extensive numerical results are reported using S-CoCo designs for Greece, Italy and Germany with both the pricing and contingent pricing models.
Keywords: contingent bonds, sovereign debt, debt restructuring, state-contingent pricing, regime switching, credit default swaps
JEL Classification: C61, C63, D61,E3, E47, E62, F34, G21, G38, H63
Suggested Citation: Suggested Citation