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ACCOUNTING NOISE AND THE PRICING OF CoCos

Author

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  • MIKE DERKSEN

    (Korteweg-de Vries Institute for Mathematics, University of Amsterdam, PO Box 94248, 1090GE Amsterdam, The Netherlands2Deep Blue Capital B.V., James Wattstraat 100-3, 1097 DM Amsterdam, The Netherlands)

  • PETER SPREIJ

    (Korteweg-de Vries Institute for Mathematics, University of Amsterdam, PO Box 94248, 1090GE Amsterdam, The Netherlands3Institute for Mathematics, Astrophysics and Particle Physics, Radboud University, Heyendaalseweg 135, 6525AJ Nijmegen, The Netherlands)

  • SWEDER VAN WIJNBERGEN

    (Economics and Business, University of Amsterdam, PO Box 15551, 1001NB Amsterdam, The Netherlands5Tinbergen Institute Amsterdam, Gustav Mahlerplein 117, 1082MS Amsterdam, The Netherlands6Centre for Economic Policy Research (CEPR), Washington, DC, USA)

Abstract

Contingent Convertible bonds (CoCos) convert into equity or are written down in times of distress. Existing pricing models assume conversion triggers based on market prices assuming that markets observe all relevant information. We incorporate that markets receive information through noisy accounting reports only, distinguish between market and accounting values and incorporate that coupon payments are subject to a Maximum Distributable Amount limit. We examine the impact of CoCo design and accounting noise on prices. Most importantly, we discuss the capital structure decision, explain why nondilutive CoCos tend to be chosen and how these increase the bank’s risk-taking incentives.

Suggested Citation

  • Mike Derksen & Peter Spreij & Sweder Van Wijnbergen, 2022. "ACCOUNTING NOISE AND THE PRICING OF CoCos," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 25(07n08), pages 1-60, November.
    • Handle: RePEc:wsi:ijtafx:v:25:y:2022:i:07n08:n:s0219024922500285
    DOI: 10.1142/S0219024922500285
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    References listed on IDEAS

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    1. Damiano Brigo & João Garcia & Nicola Pede, 2015. "Coco Bonds Pricing With Credit And Equity Calibrated First-Passage Firm Value Models," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 18(03), pages 1-31.
    2. Avdjiev, Stefan & Bogdanova, Bilyana & Bolton, Patrick & Jiang, Wei & Kartasheva, Anastasia, 2020. "CoCo issuance and bank fragility," Journal of Financial Economics, Elsevier, vol. 138(3), pages 593-613.
    3. Stephanie Chan & Sweder van Wijnbergen, 2016. "Coco Design, Risk Shifting Incentives and Capital Regulation," Tinbergen Institute Discussion Papers 16-007/VI, Tinbergen Institute, revised 13 Nov 2017.
    4. Merton, Robert C, 1974. "On the Pricing of Corporate Debt: The Risk Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 29(2), pages 449-470, May.
    5. Kiewiet, Gera & van Lelyveld, Iman Paul Pieter & van Wijnbergen, Sweder, 2017. "Contingent Convertibles: Can the Market handle them?," CEPR Discussion Papers 12359, C.E.P.R. Discussion Papers.
    6. Charles W. Calomiris & Richard J. Herring, 2013. "How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too-Big-to-Fail Problem," Journal of Applied Corporate Finance, Morgan Stanley, vol. 25(2), pages 39-62, June.
    7. Nan Chen & Paul Glasserman & Behzad Nouri & Markus Pelger, 2013. "CoCos, Bail-In, and Tail Risk," Working Papers 13-04, Office of Financial Research, US Department of the Treasury.
    8. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
    9. Suresh Sundaresan & Zhenyu Wang, 2015. "On the Design of Contingent Capital with a Market Trigger," Journal of Finance, American Finance Association, vol. 70(2), pages 881-920, April.
    10. Paul Glasserman & Behzad Nouri, 2012. "Contingent Capital with a Capital-Ratio Trigger," Management Science, INFORMS, vol. 58(10), pages 1816-1833, October.
    11. Nan Chen & Paul Glasserman & Behzad Nouri & Markus Pelger, 2013. "CoCos, Bail-In, and Tail Risk," Working Papers 13-01, Office of Financial Research, US Department of the Treasury.
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    Citations

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    Cited by:

    1. Ioana Neamtu, 2020. "Multiple buffer CoCos and their impact on financial stability," Tinbergen Institute Discussion Papers 20-010/IV, Tinbergen Institute.
    2. Fatouh, Mahmoud & Neamțu, Ioana & van Wijnbergen, Sweder, 2021. "Risk-taking and uncertainty: do contingent convertible (CoCo) bonds increase the risk appetite of banks?," Bank of England working papers 938, Bank of England.
    3. 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 capital pricing; accounting noise; CoCo triggers; CoCo design; risk taking incentives; investment incentives;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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