Accounting Noise and the Pricing of CoCos

TL;DR

This paper develops a model for CoCo bond pricing that accounts for noisy accounting information, regulatory triggers, and contingent coupon payments, providing insights into market behavior and risk management.

Contribution

It introduces a novel CoCo pricing framework incorporating noisy accounting data, regulatory triggers, and contingent coupons, enhancing understanding of CoCo valuation and risk.

Findings

Accounting noise significantly affects CoCo prices.

Design parameters influence risk-taking incentives.

Model explains the 2016 Deutsche Bank CoCo price crash.

Abstract

Contingent Convertible bonds (CoCos) are debt instruments that convert into equity or are written down in times of distress. Existing pricing models assume conversion triggers based on market prices and on the assumption that markets can always observe all relevant firm information. But all Cocos issued so far have triggers based on accounting ratios and/or regulatory intervention. We incorporate that markets receive information through noisy accounting reports issued at discrete time instants, which allows us to distinguish between market and accounting values, and between automatic triggers and regulator-mandated conversions. Our second contribution is to incorporate that coupon payments are contingent too: their payment is conditional on the Maximum Distributable Amount not being exceeded. We examine the impact of CoCo design parameters, asset volatility and accounting noise on the price of a CoCo; and investigate the interaction between CoCo design features, the capital structure of the issuing bank and their implications for risk taking and investment incentives. Finally, we use our model to explain the crash in CoCo prices after Deutsche Bank's profit warning in February 2016.