Structural Pricing of CoCos and Deposit Insurance with Regime Switching and Jumps
Asia-Pacific Financial Markets Vol. 27, N°4, p. 477–520, 2020
42 Pages Posted: 19 Jan 2018 Last revised: 2 Dec 2020
Date Written: February 11, 2018
In this article, we construct a structural model with jumps and regime switching to price banks' contingent convertible debt (CoCos) and deposit insurance. We use an Esscher transform that is applicable to regime switching double exponential jump diffusions to move from the historical world to the risk-neutral world. Further, we define and implement a matrix Wiener-Hopf factorization associated with the latter processes, allowing us to price the various components of a bank's balance sheet. Thus, we obtain valuation formulas for the bank's equity, debt, deposits, CoCos, and deposit insurance. We also show in an illustration the respective effects of the jump risk and of regime switching on the values of all of a bank's balance sheet components.
Keywords: Structural model; Regime switching; Jump-diffusion; Matrix Wiener-Hopf factorization; Esscher transform; CoCos; Deposit insurance; Fluid embedding; Markov chain
JEL Classification: G13; G21; G32
Suggested Citation: Suggested Citation