Estimating Contingent Convertible credit spreads in the Norwegian Bond Market using an option pricing approach

Abstract

In this paper we model credit spreads on contingent convertible bonds (CoCos) in the Norwegian financial bond market, using a Merton-style option model approach. We examine whether the Merton risk default model provides a good measure of CoCo bond prices. We find that this model, although favoured by its simplicity, is overly sensitive to changes in the volatility of firm asset values, and fails to account for liquidity premiums. We further ask if CoCo prices account for the prepayment risk that are unique to these hybrid, equity-like capital instruments. Analogously, we ask if CoCo bonds offer cheap funding for banks relative to equity capital. We find no evidence that bond markets under-price the CoCo risk of the trial banks. Still, we find that CoCos offer cheap funding for banks relative to issuing equity capital. In addition, CoCos offer a capital cushion for banks when most needed.