Pricing Contingent Convertible Capital: An Empirical Approach
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This thesis develops a novel empirical approach to price contingent convertible bonds (CoCos) with a Core Tier 1 (CT1) ratio trigger. Existing models on CoCo pricing all develop a process linking a proxy of the trigger with the stock price, but we find that the proxies used are not representative for the CT1 ratio. In particular, they all imply high correlation with the stock price and fail to incorporate the bank’s control of the ratio through their risk management. As we find the correlation between the trigger and the stock price to be historically insignificant, we model them as independent processes. Their evolution is estimated based on historical data, while allowing the bank to have a target for their capital adequacy ratio. To test our model and check its sensitivity to the input data, we study the Credit Suisse CoCo issue of March 20th, 2012. According to our best estimate, including information likely incorporated by investors, the CoCo is underpriced by the market.