Contingent convertible bonds with the default risk premium

• Published in: International review of financial analysis Vol. 59; pp. 77 - 93
• Main Authors: Jang, Hyun Jin, Na, Young Hoon, Zheng, Harry
• Format: Journal Article
• Language: English
• Published: Elsevier Inc 01.10.2018
• Subjects: Capital-ratio trigger; Contingent convertible bond; Conversion time; Equity-conversion CoCo; Post-conversion risk premium; Equity-conversion CoCo; C67; Conversion time; G13; Contingent convertible bond; Capital-ratio trigger; Post-conversion risk premium
• ISSN: 1057-5219; 1873-8079
• DOI: 10.1016/j.irfa.2018.07.003

Contingent convertible bonds (CoCos) are hybrid instruments characterized by both debt and equity. CoCos are automatically converted into equity or written down when a predefined trigger event occurs. The present study quantifies the issuing bank's default risk that only manifests in the post-conversion period for pricing CoCos depending on a loss-absorbing method. This work aims to reflect the distinct features of equity-conversion CoCos - in contrast to a write-down CoCos - in a valuation framework. Accordingly, we propose a model to compute the ratio of common equity Tier 1 (CET1), which is composed of core capital and risky assets, by employing a geometric Brownian motion and a random variable. Then, we formulate the post-conversion risk premium by measuring the probability with which the bank's CET1 ratio breaches a regulatory default threshold after conversion. Finally, we empirically examine a positive value of the post-conversion risk premium embedded in the market prices of equity-conversion CoCos. •We quantify the issuing bank's default risk that only manifests in the post-conversion period for pricing CoCos.•We model the ratio of common equity Tier 1 by employing a geometric Brownian motion and a random variable.•We define new notions of ‘regulatory default’ and ‘post-conversion risk’.•We formulate the post-conversion risk premium by measuring regulatory default probability as an analytic form.•We empirically examine the post-conversion risk premium embedded in the market prices of equity-conversion CoCos.