Contingent Convertible Bonds. A Market-Conform Equity Derivative Model

Abstract: This thesis focuses on the pricing of the Contingent Convertible Bonds (CoCos), using the Equity Derivative approach and the Bates model to simulate the stock price with Monte Carlo algorithm. The CoCo bonds are hybrid financial instruments with loss-absorbency features, characterized by a conversion into equity or a write-down of the face value, when a specified trigger event happens, which is usually related to an accounting indicator of the bank. The Equity Derivative model prices the CoCos under the assumption of the Black-Scholes volatility, converting the accounting trigger into a market trigger. Instead, the thesis aims to underlining the impact of a more market-conform path of the stock price. Hence, the Bates model is considered more suitable in this pricing framework, allowing the stock prices to have sudden jumps and a time-varying volatility. Therefore, the comparison between the Bates and the Black-Scholes models is made within the Equity Derivative framework. The market trigger is unobservable, thus the analysis of the CoCo prices is done indirectly. Namely, matching the model prices with the observed market prices of two categories of Barclays CoCos, the levels of the implied market trigger are inferred. The higher they are, the higher trigger probabilities should be. However, while the Bates extension provides a market trigger greater than the one in the Black-Scholes case, the related trigger probabilities are lower, overturning the interpretation for which the Bates model provides a riskier valuation of the CoCos. Finally, a number of factors that impact on the model applicability are considered, showing how a complex structure of the CoCo is difficult to be captured by an implied-market approach, as the formulated extension of the Equity Derivative model.