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Contingent convertible bonds with floating coupon payments: fixing the equilibrium problem

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  • Daniël Vullings

Abstract

Contingent convertible bonds (CoCos) are increasingly popular financial instruments used by banks to satisfy capital requirements. CoCos with market-based conversion triggers in particular receive much attention in the literature. The pricing of CoCos with such a market trigger is problematic as the market value of equity itself depends on the firm's capital structure. This results in a not-unique arbitrage-free price for the CoCos. We propose a new type of CoCos with a market based trigger and floating coupons. The coupons increase near the trigger value to compensate CoCo holders for the possibility of bankruptcy before conversion. This leads to a unique no-arbitrage price before conversion. The properties of the innovative CoCo contract are studied for different dynamic models of a bank's assets, such as the (Black-Scholes) Merton and stochastic volatility jump diffusion model. In particular, we illustrate how the CoCo coupons vary as functions of jump intensities and volatilities.

Suggested Citation

  • Daniël Vullings, 2016. "Contingent convertible bonds with floating coupon payments: fixing the equilibrium problem," DNB Working Papers 517, Netherlands Central Bank, Research Department.
  • Handle: RePEc:dnb:dnbwpp:517
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    More about this item

    Keywords

    Contingent Convertible bonds; market trigger; floating coupons;

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • 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

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