Pricing Contingent Convertibles: A Derivatives Approach

A major question raised in the 2008 financial crisis and its aftermath has been how a bank, or any financial institution, can strengthen its balance sheet after a major loss during a period of market unrest, when selling stock in the equity market on reasonable terms is unfeasible. Contingent convertible securities (CoCos) have been proposed as one solution. A CoCo is a debt instrument that automatically converts to equity upon the occurrence of a prespecified credit-related event, such as exceeding a trigger value for its core tier-1 capital ratio, or for the spread on credit default swaps that reference it in the market. Pricing approaches for CoCos either treat them as a kind of credit derivative, or alternatively, more like callable bonds. In the first case, the stock that would replace the CoCo following a trigger event plays the role of the recovery rate in a default risk model. The second approach focuses on conversion of a CoCo as being like exercise of a put option, in which the issuer puts shares to the CoCo holders, with the value of their bond-like security as the exercise price. Spiegeleer and Schoutens present both kinds of models and then show how each would handle a particular real world CoCo issued by Lloyds Banking Group.