In the year 2007 one of the biggest financial crisis in worlds history has begun. It
leads to the bankruptcy of huge financial institution followed by the bailout of banks
through the national government and a downturn in worldwide stock markets. The
financial crisis has also shown that the capitalizations of numerous financial institutes
were not adequate and several components of banks equity could not fulfil their
planned function. To save the global financial system from collapsing many banks
received lot of money from the government.
To avoid another future crisis and huge bailouts by the national government, some
financial experts and leading economists proposed a new financial instrument, called
Contingent Convertibles Bonds (“CoCo-Bonds”). They are considered to be an
opportunity to improve the equity base of banks in times of crisis. CoCo-Bonds are a
special form of bonds, which convert automatically to equity after a predefined
incidence.
Three large banks have already issued these new financial instruments; The Lloyds
Banking Group (2009), Rabobank (2010) and the Credit Suisse (2011). The aim of
this paper is to analyse the structure and the pricing of these already issued CoCo-
Bonds. In the first part the functionality of the CoCo-Bonds will be explained. It will
also provide a summary of the specification of the already issued CoCo-Bonds. The
third part, which is the main part, is focused on the pricing modalities of these new
financial instruments. Two different approaches will be considered. First the credit
derivatives approach and seconds the equity derivatives approach. In the end of the
paper both approaches will be applied to the already issued CoCo-Bonds of Lloyds
and Credit Suisse.
Table of Contents
I Introduction
II The mechanism of CoCo-Bond
2.1 Backgrounds and functionality
2.2 Definition of the Trigger Event
2.2.1 The Market Trigger
2.2.2 The Accounting Trigger
2.2.3 The Regulatory Trigger
2.2.4 The Multi-Variante Trigger
2.3 The Specification of a Conversion
2.3.1 The conversion fraction (α)
2.3.2 The conversion ratio Cr and the conversion price Cp
2.4 The Specifications of already issued CoCo-Bonds
III The Pricing of CoCo-Bonds
3.1. Introduction
3.2. The Credit Derivatives Approach
3.2.1 The Loss
3.2.2 The Trigger Intensity λTrigger
3.3. The Equity Derivative Approach
3.3.1 The Pricing of a Zero Coupon CoCo-Bond
3.3.2 The Pricing of a CoCo-Bond with Coupons
3.4 Calculation Examples on the Basis of already issued CoCo-Bonds
3.4.1 Example for the Credit Derivatives Approach (Case Study Credit Suisse)
3.4.2 Example for the Equity Derivatives Approach (Case Study Lloyds)
IV Conclusion
Objectives and Topics
The primary objective of this paper is to analyze the structural design and the pricing modalities of Contingent Convertible Bonds (CoCo-Bonds) issued by major financial institutions. The paper addresses how these hybrid financial instruments function as a tool for bank recapitalization during crises and evaluates mathematical approaches to determine their fair value.
- Functionality and mechanisms of CoCo-Bonds
- Definition and classification of different trigger events
- Pricing methodologies using credit derivative and equity derivative approaches
- Case studies on existing CoCo-Bonds from Credit Suisse and Lloyds Banking Group
- Sensitivity analysis regarding underlying share prices and trigger probabilities
Excerpt from the Book
2.2.1 The Market Trigger
Proposed by Flannery one opportunity is the application of market values for the trigger event. The conversion would take place automatically if the share price falls under a predefined barrier. Alternatively also CDS prices could serve as trigger event. One central argument for the adoption of a market trigger is the objective of market prices. The requirements for transparency and clarity are also comply with the choice of market prices for the trigger event, because share prices could be observed at any time without much effort. In addition to that market prices are always up-to date. With the choice of market prices for the trigger event the conversion is dependent on the behaviour and expectations of the market, which determinates the prices for share or CDS. So the conversion wouldn’t fall to the valuation of a regulatory instance.
Summary of Chapters
I Introduction: Provides an overview of the financial crisis context and introduces CoCo-Bonds as a preventive measure to strengthen bank equity.
II The mechanism of CoCo-Bond: Explains the functionality, trigger modes, and specific design features of existing Contingent Convertible Bonds.
III The Pricing of CoCo-Bonds: Detailed mathematical derivation of pricing models based on credit and equity derivatives, including application examples.
IV Conclusion: Summarizes the importance of CoCo-Bonds for systemic stability and emphasizes the necessity of transparent trigger definitions for accurate pricing.
Keywords
CoCo-Bonds, Contingent Convertibles, Pricing, Credit Derivatives, Equity Derivatives, Market Trigger, Accounting Trigger, Regulatory Trigger, Bank Recapitalization, Financial Crisis, Conversion Ratio, Trigger Intensity, Barrier Options, Credit Spread, Basel III
Frequently Asked Questions
What is the core subject of this term paper?
The paper focuses on the structural analysis and mathematical pricing of Contingent Convertible Bonds (CoCo-Bonds), which are hybrid financial instruments designed to automatically convert into equity during financial distress.
What are the central thematic areas covered?
The main themes include the classification of conversion triggers (market, accounting, regulatory), the specification of conversion parameters, and the application of financial modeling to value these instruments.
What is the primary research goal?
The goal is to explain how CoCo-Bonds function and to apply specific pricing approaches—namely credit derivatives and equity derivatives models—to real-world issued bonds.
Which scientific methods are employed?
The author uses a theoretical analysis of financial literature followed by a quantitative approach, utilizing Black-Scholes barrier option pricing and intensity-based credit modeling to calculate theoretical bond values.
What does the main part of the paper cover?
The main part provides the mathematical foundation for pricing CoCo-Bonds, evaluating components like loss absorption, trigger intensity, and the valuation of the bond, forward, and option parts within the structure.
Which keywords best characterize this work?
Key terms include CoCo-Bonds, Pricing, Market Trigger, Credit Derivatives, Equity Derivatives, and Basel III.
Why is the "Market Trigger" often criticized despite its transparency?
It is criticized because market participants can act irrationally, market efficiency is not guaranteed, and share prices are susceptible to manipulation, which could trigger a conversion when not strictly necessary for stability.
How does the Equity Derivative Approach structure a CoCo-Bond?
It decomposes the CoCo-Bond into a combination of a traditional zero-coupon bond and a series of "knock-in" forwards, effectively modeling the potential purchase of shares at a specific trigger price.
- Arbeit zitieren
- Melanie Prossliner (Autor:in), 2011, The Pricing of already issued Contingent Convertible Bonds (CoCo-Bonds), München, GRIN Verlag, https://www.hausarbeiten.de/document/207354
