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Contingent convertible bonds with the default risk premium

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  • Jang, Hyun Jin
  • Na, Young Hoon
  • Zheng, Harry

Abstract

Contingent convertible bonds (CoCos) are hybrid instruments characterized by both debt and equity. CoCos are automatically converted into equity or written down when a predefined trigger event occurs. The present study quantifies the issuing bank's default risk that only manifests in the post-conversion period for pricing CoCos depending on a loss-absorbing method. This work aims to reflect the distinct features of equity-conversion CoCos - in contrast to a write-down CoCos - in a valuation framework. Accordingly, we propose a model to compute the ratio of common equity Tier 1 (CET1), which is composed of core capital and risky assets, by employing a geometric Brownian motion and a random variable. Then, we formulate the post-conversion risk premium by measuring the probability with which the bank's CET1 ratio breaches a regulatory default threshold after conversion. Finally, we empirically examine a positive value of the post-conversion risk premium embedded in the market prices of equity-conversion CoCos.

Suggested Citation

  • Jang, Hyun Jin & Na, Young Hoon & Zheng, Harry, 2018. "Contingent convertible bonds with the default risk premium," International Review of Financial Analysis, Elsevier, vol. 59(C), pages 77-93.
    • Handle: RePEc:eee:finana:v:59:y:2018:i:c:p:77-93
    DOI: 10.1016/j.irfa.2018.07.003
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    References listed on IDEAS

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    1. Nan Chen & Paul Glasserman & Behzad Nouri & Markus Pelger, 2017. "Contingent Capital, Tail Risk, and Debt-Induced Collapse," The Review of Financial Studies, Society for Financial Studies, vol. 30(11), pages 3921-3969.
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    3. Yang, Zhaojun & Zhao, Zhiming, 2015. "Valuation and analysis of contingent convertible securities with jump risk," International Review of Financial Analysis, Elsevier, vol. 41(C), pages 124-135.
    4. Hilscher, Jens & Raviv, Alon, 2014. "Bank stability and market discipline: The effect of contingent capital on risk taking and default probability," Journal of Corporate Finance, Elsevier, vol. 29(C), pages 542-560.
    5. Martynova, Natalya & Perotti, Enrico, 2018. "Convertible bonds and bank risk-taking," Journal of Financial Intermediation, Elsevier, vol. 35(PB), pages 61-80.
    6. Tsz-Kin Chung & Yue-Kuen Kwok, 2016. "Enhanced equity-credit modelling for contingent convertibles," Quantitative Finance, Taylor & Francis Journals, vol. 16(10), pages 1511-1527, October.
    7. McDonald, Robert L., 2013. "Contingent capital with a dual price trigger," Journal of Financial Stability, Elsevier, vol. 9(2), pages 230-241.
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    9. Corcuera, José Manuel & De Spiegeleer, Jan & Fajardo, José & Jönsson, Henrik & Schoutens, Wim & Valdivia, Arturo, 2014. "Close form pricing formulas for Coupon Cancellable CoCos," Journal of Banking & Finance, Elsevier, vol. 42(C), pages 339-351.
    10. Jan De Spiegeleer & Stephan Höcht & Ine Marquet & Wim Schoutens, 2017. "CoCo bonds and implied CET1 volatility," Quantitative Finance, Taylor & Francis Journals, vol. 17(6), pages 813-824, June.
    11. Paul Glasserman & Behzad Nouri, 2012. "Contingent Capital with a Capital-Ratio Trigger," Management Science, INFORMS, vol. 58(10), pages 1816-1833, October.
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    Cited by:

    1. Michael Sigmund & Kevin Zimmermann, 2021. "Determinants of Contingent Convertible Bond Coupon Rates of Banks: An Empirical Analysis (Michael Sigmund, Kevin Zimmermann)," Working Papers 236, Oesterreichische Nationalbank (Austrian Central Bank).
    2. Javadi, Siamak & Li, Weiping & Nejadmalayeri, Ali, 2023. "Contingent capital conversion under dual asset and equity jump–diffusions," International Review of Financial Analysis, Elsevier, vol. 89(C).
    3. Piotr Jaworski & Kamil Liberadzki & Marcin Liberadzki, 2021. "On Write-Down/ Write-Up Loss Absorbing Instruments," European Research Studies Journal, European Research Studies Journal, vol. 0(1), pages 1204-1219.
    4. Philippe Oster, 2020. "Contingent Convertible bond literature review: making everything and nothing possible?," Journal of Banking Regulation, Palgrave Macmillan, vol. 21(4), pages 343-381, December.

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    More about this item

    Keywords

    Contingent convertible bond; Capital-ratio trigger; Conversion time; Equity-conversion CoCo; Post-conversion risk premium;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C67 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Input-Output Models

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