First-Passage Time Model Driven by Lévy Process for Pricing CoCos

Contingent convertible bonds (CoCos) are typical form of contingent capital that converts into equity of issuing firm or writes down if a prespecified trigger occurs. This paper proposes a general Levy framework for pricing CoCos. The Levy framework indicates that the difficulty in giving closed-form expression for CoCos price is the possible introduction of the Levy process whose first-passage time problem has not been solved. According to characteristics of new Levy measure after the measure transform, three specific Levy models driven by drifted Brownian motion, spectrally negative Levy process, and double exponential jump diffusion process are proposed to give the solution keeping the form of the driving process unchanged under the measure transform. These three Levy models provide closed-form expressions for CoCos price while the latter two possess them up to Laplace transform, whose pricing results are given by combining with numerical Fourier inversion and Laplace inversion. Numerical results show that negative jumps have large influence on CoCos pricing and the Black-Scholes model would overestimate CoCos price by simply compressing jumps information into volatility while the other two models would give more accurate CoCos price by taking jump risk into consideration.