Modelling and Pricing Contingent Convertibles

Abstract

Recent years financial turbulence has energized implementation of comprehensive regulatory standards on bank capital adequacy. Regulators demand more capital with loss absorbance properties and the Contingent Convertible bond, CoCo, has become an increasingly pop- ular way to gather such capital. A CoCo automatically and mandatorily converts to loss absorbing regulatory capital before the point of non-viability and hence instantly improves the capital structure of the distressed bank. To date, only a few CoCos have been issued but we expect the market to grow rapidly with new and tighter regulation of bank capital adequacy. This thesis examines how pricing of such blended debt and equity products can be modelled. We examine existing methods, develop them further to improve the estima- tion precision and present a real world implementation on Swedbank’s potentially upcoming issue of CoCos. The application also includes sensitivity analysis to further understand the dynamics of the different methodologies.