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

DNB Working Papers
Date 5 August 2016
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.
Keywords: Contingent Convertible bonds, market trigger, floating coupons.
JEL classifications: G13, G21, G28.