CoCo Bonds Valuation with Equity- and Credit-Calibrated First Passage Structural Models

by Damiano Brigo of Imperial College, London,
João Garcia - Independent Consultant, UK, and
Nicola Pede of Imperial College, London

February 28, 2013

Abstract: After the beginning of the credit and liquidity crisis, financial institutions have been considering creating a convertible-bond type contract focusing on Capital. Under the terms of this contract, a bond is converted into equity if the authorities deem the institution to be under-capitalized. This paper discusses this Contingent Capital (or Coco) bond instrument and presents a pricing methodology based on firm value models. The model is calibrated to readily available market data. A stress test of model parameters is illustrated to account for potential model risk. Finally, a brief overview of how the instrument performs is presented.

JEL Classification: G13.

AMS Classification: 91B70.

Keywords: Contingent Capital, CoCo Bonds, AT1P model, Firm Value Models, Credit Default Swap Calibration, Conversion Time, Default Time, Hybrid Credit-Equity Products, Basel III, Systemic Risk.

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