CoCo Bonds Valuation with Equity- and Credit-Calibrated First Passage Structural Models

TL;DR

This paper introduces a valuation method for CoCo bonds using equity- and credit-calibrated first passage structural models, addressing the need for accurate pricing amid financial crises.

Contribution

It develops a calibration approach for CoCo bond pricing models based on market data and includes stress testing for model risk assessment.

Findings

Model calibration aligns with market data

Stress tests reveal parameter sensitivities

Brief performance overview of CoCo bonds

Abstract

After the beginning of the credit and liquidity crisis, financial institutions have been considering creating a convertible-bond type contract focusing on Capital. Under the terms of this contract, a bond is converted into equity if the authorities deem the institution to be under-capitalized. This paper discusses this Contingent Capital (or Coco) bond instrument and presents a pricing methodology based on firm value models. The model is calibrated to readily available market data. A stress test of model parameters is illustrated to account for potential model risk. Finally, a brief overview of how the instrument performs is presented.