Pricing sovereign contingent convertible debt

TL;DR

This paper introduces a novel pricing model for Sovereign Contingent Convertible bonds that incorporates regime-switching CDS spreads and uses simulation within an American option framework for risk management.

Contribution

It develops a new pricing approach for S-CoCo bonds that accounts for regime-switching CDS spreads and includes dual trigger pricing mechanisms.

Findings

Numerical results for Greece, Italy, and Germany demonstrate the model's applicability.

The model effectively captures crisis-related spread regime switches.

Dual trigger pricing offers a comprehensive risk management tool.

Abstract

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. We model CDS spread regime switching, which is prevalent during crises, as a hidden Markov process, coupled with a mean-reverting stochastic process of spread levels under fixed regimes, in order to obtain S-CoCo prices through simulation. The paper uses the pricing model in a Longstaff-Schwartz American option pricing framework to compute future state contingent S-CoCo prices for risk management. Dual trigger pricing is also discussed using the idiosyncratic CDS spread for the sovereign debt together with a broad market index. Numerical results are reported using S-CoCo designs for Greece, Italy and Germany with both the pricing and contingent pricing models.