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Contingent Conversion Convertible Bond: New avenue to raise bank capital

Francesca Di Girolamoa,b Francesca Campolongoa , Jan De Spiegeleerb,c , , Wim Schoutensb

European Commission, JRC, Via E. Fermi 2749, 21027 Ispra (VA), Italy b Department of Mathematics, KU Leuven, Leuven, Belgium c Head of Risk Management, Jabre Capital Partners - Geneva
Abstract This paper provides an in-depth analysis into the structuring and the pricing of an innovative nancial market product. This instrument is called contingent conversion convertible bond or CoCoCo. This hybrid bond is itself a combination of two other hybrid instruments: a contingent convertible (CoCo) and a convertible bond. This combination introduces more complexity in the structure but it now allows investors to prot from strong share price performances. This upside potential is added on top of the normal contingent convertible mechanics whereas CoCos only expose the investors to downside risk. This sets up a new avenue for the banks to create new capital. First, we explain how the features of the contingent convertible bonds on one side and the features of the standard convertible bonds on the other side are combined. Thereafter, we propose a pricing approach which moves away from the standard Black&Scholes setting. The CoCoCos are evaluated using the Heston process to which a Hull-White interest rate process has been added. We demonstrate the importance of using a stochastic interest rate when modeling this instrument. Finally we quantify the loss absorbing capacity of this instrument. JEL Classication: G13, G18, G21, C15

Keywords: Convertible bonds, Contingent convertible bonds, Monte Carlo simulations, Sensitivity analysis

Contact information: Phone: +39 0332 78 5187, Fax: +39 0332 78 5733, Email address: francesca.di-girolamo@jrc.ec.europa.eu

Electronic copy available at: http://ssrn.com/abstract=2196339

Introduction

In the light of the 2008 credit crisis which has hit the whole nancial market, some capital instruments used to fund the operations of a nancial institution have disappointed. Their quality and consistency showed fundamental aws. A bank funds itself by issuing equity (shares) and debt instruments. Its regulatory capital can be decomposed into Tier 1 and Tier 2. Tier 1 consists of a core Tier 1 component and a layer of additional Tier 1. The core Tier 1 layer is top quality capital. It consists of equity and retained earnings and is fully loss absorbing. The other component, additional Tier 1, consists for example of preferreds, perpetuals often combined with features such as cancellable coupons. The Tier 2 bucket on a banks balance sheet ranks above Tier 1 debt. Shareholders or investors in Tier 1 debt would rst have to loose their investment before Tier 2 instruments start suering. Tier 2 contains for example subordinated debts. In the aftermath of the credit crisis one can state that the equity capital held by banks was far too little in relation to the risks they were running (Independent Commission on Banking (2011)). To make matters worse, the additional Tier 1 did not full the role it was designed for. It failed to be loss absorbing and banks needed to be bailed out by the tax payers. This has driven the Basel Committee (Basel Committee (2010); Basel Committee (2011a)) to be stricter on the allowance of certain hybrid instruments that used to be part of this layer of additional Tier 1. A debt instrument can have the status of regulatory capital if it is loss absorbing. Practically this means there has to be a conversion into shares or a write down of the face value of the bond when the bank reaches a state of non-viability. In this context, the contingent convertible bonds (CoCos) tick all the boxes and they are a kind of automatic reinforcement of the banks balance sheet, a mechanism which would reduce the overall systemic risk. They are loss absorbing and impose losses to their investors as soon as the bank gets into a threatening situation. The loss absorption takes place with a conversion of these bonds into equity. The balance sheet is hence automatically reinforced and the bank sees its debt load to be reduced.
LLOYDS Name Issue Date Issue Size (m) Regulatory Ranking Trigger Write-Down Enhanced Capital Notes November 2009 $13,700 Tier 2 Core Tier 1 < 5% Equity Capital Ratio < 7% 75% with immediate repayment of 25% Conversion Conversion Price Maturity (years) Callable Fixed Coupon Optional Conversion Full Conversion in Shares 59 GBp 10 - 22 6.385-16.125 6.875 10 8.375 Equity Capital Ratio < 8% Write down depends on the capital needs. Full Conversion in Shares max(20USD,20CHF, S*) 30 After 5.5 years 7.875 10 After 5 years 7.125 Full Conversion in Shares max(80% S* , 1 EUR) Perpetual After 5 years 6.5 Yes at 3.3 After 5 years 7.25 No RABO Senior Contingent Notes March 2010 e 1,250 January 2011 $2,000 CREDIT SUISSE Buer Capital Notes February 2011 $2,000 Tier 2 Core Tier 1 < 7% March 2012 CHF 750 BANK OF CYPRUS CoCoCo May 2011 e 890 Tier 1 Core Tier 1 < 5% February 2012 $2,000 Lower Tier 2 Core Tier 1 < 5% 100% UBS

Table 1: Features of some issued CoCo bonds

Electronic copy available at: http://ssrn.com/abstract=2196339

The pioneer in this new asset class has been the Lloyds Banking Group when it exchanged in November 2009 series of contingent convertible bonds (ODoherty (2009)). Investors would receive shares when the core Tier 1 ratio of the bank falls below a trigger level of 5%. Lloyds was soon followed by Rabobank in March 2010. This CoCo issue handled the loss absorbency through a haircut of 75%. The Rabobank issue was very well accepted by the market which lead Credit Suisse to embrace the contingent convertible concept in February 2011 (Hughes and Jenkins (2011); Swiss National Bank (2010)). The possibility of using contingent convertibles to count towards the regulatory capital fuelled the interest for this new bond (see Table 1 where the most important issued CoCo bonds have been presented). For a while, a consensus was growing among the market participants that contingent convertible bonds were going to allow to meet the extra capital surcharge of the so-called systemically important nancial institutions (SIFIs). Although, the Basel Committee disallowed early July 2011 the use of CoCos to handle the SIFIs capital surcharge (Basel Committee (2011b)), CoCos would denitively nd their way in the bucket of addition Tier 1 or Tier 2. Their loss absorbency is going to play a relevant role in the capital requirements imposed by national regulators: (see Figure 1).

Figure 1: Capital Requirements under Basel III Standardisation will not be the norm in CoCo-land since dierent forms of contingent convertible bonds already have emerged. Up till the writing of this paper, there has been a large variety in trigger levels, host instruments, use of regulatory triggers, and coupon structures. The Bank of Cyprus for example came in April 2011 with a special convertible bond called Convertible Enhanced Capital Securities (CECS) 1 . This newcomer has
CECSs had been exchanged via the issue of another hybrid called Mandatory Convertible Notes (MCNs) as part of a recapitalization plan on 20 March 2012. The MCNs had a duration of eight calendar days and they had been redeemed with new shares on 27 March 2012 (Bank of Cyprus
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set out a twist which opens the door to a new investor base (Khasawned and Agnew (2011); Whittaker (2011)). The CECS is not a standard contingent convertible bond but it embraces some features of traditional convertible bonds (from here the name CoCoCo). Although this introduces more complexity in the structure, the most interesting idea is to allow investors to prot from good times. The traditional CoCo bond forces losses onto the investor when a trigger event is materialised. A CoCo investor typically becomes a shareholder in bad times or suers a write-down. There is no particular upside for the CoCo investor, the best outcome is to receive all the coupons and the face value of the bond up to the expiry of this debt instrument. The holder of a CoCoCo has an extra feature on top of the mandatory conversion. The investor also has an optional conversion possibility: in case of a good share price performance, the investor can convert the bond into a pre-determined amount of shares. Summarizing we say that the conversion of this CoCoCo bond can thus take place in two dierent situations: bad times when the bank is becoming insolvent or the opposite case when shares are performing well. The research on convertible bonds is well developed. A number of studies has been dedicated to this subject (Kind and Wilde (2005); Jan de Spiegeleer and Schoutens (2011b); Davis and Lischka (2002)) and the interest dates back to 1980 when Schwartz proposed a pricing approach for such bonds. CoCos as well have started to be a topic of research unlike they are novel nancial instruments. The literature proposes some detailed descriptions on their features and some pricing models have already been proposed (see for example Maes and Schoutens (2012); Jan de Spiegeleer and Schoutens (2011a); Jan de Spiegeleer and Schoutens (2011c); McDonald (2010)). The contributions in Pennacchi (2011) and Barucci and Del Viva (2012) focus on investigating the structure of a general company issuing CoCo bonds. Moreover, Pennacchi and Vermaelen (2011) propose to issue a special kind of CoCos called COERC, Flannery (2009) proposes to issue Contingent Capital Certicates. Concerning with the CoCoCo bonds instead, we are not aware of any other quantitative analysis. This paper tries to provide an in-depth analysis into the valuation and the dynamics of this innovative nancial market product. The remaining of the paper is organized as follows: Section 2 focuses on the structure of the CoCoCo bonds and their features; Section 3 describes our pricing methodology; Section 4 discusses the results when applying the proposed methodology to a CoCoCo prototype; Particular attention has been given to the stochastic interest rate by investigating how it aects the CoCoCo price; A quantication of the loss absorbing capacity of this instrument is provided here as well; Section 5 concludes.
(2012)).

CoCoCo: Contingent Conversion Convertible

Standard contingent convertible bonds (CoCos) are debt instruments on top of which a loss absorption mechanism has been implemented. This loss absorption takes place through a mandatory conversion into equity (shares) or a write down. Upon a conversion, the bank immediately receives new equity and all future coupons are canceled. The combination of a CoCo and a convertible bond creates a contingent conversion convertible bond (CoCoCo). The mandatory conversion will take place during a distressed situation. In such a case a trigger measuring the nancial health of the bank forces this conversion into shares. This is the downside risk of a CoCoCo which is the same as the risk carried by a CoCo. The optional conversion is in the hand of the investor and will be exercised when the share price is far enough above the conversion price.

2.1

Risk Prole

The risk prole of a CoCoCo is a combination of the prole of a CoCo and a convertible. For CoCos the bond nature would predominate in good states of the economy capping the maximum possible payo to the face value of the bond. This is exactly the reason why buying CoCos puts investors in a situation of getting a limited gain with a probability of ending up with high losses. This carries negative convexity for the investor, the worse the nancial condition of the bank the more the investor is exposed to the share price of the bank. Standard convertibles have the opposite convexity prole. The investor has less direct exposure to price movements of the underlying share in downturns. In fact, he will never convert into shares when these are trading below the conversion price. Figure 2 shows the two risk proles: unlimited downside - limited upside for CoCos and the limited downside - unlimited upside for convertibles (Jan de Spiegeleer and Schoutens (2011b); Jan de Spiegeleer and Schoutens (2011a)). Note that the upper boundary of the rst one acts at the same time as a lower boundary for the second one. The bond oor of the convertible is a bond ceiling for the CoCo.

2.2

Framework

The value of CoCoCos depends on their anatomy. There are two faces that have to be carefully considered. On one side there is a distressed situation which requires to set up an automatic mechanism to get a mandatory conversion. On the other side, there is a time in which investors can enjoy of an optional conversion into shares

Bond Floor

Bond Price

Convertible Bond CoCo Bond

Stock Price, S

Figure 2: CoCo vs Convertible Risk Prole

whenever it would be protable. The structuring of a CoCoCo is a trade-o to reconcile the interests of investors, regulators, and shareholders. Investors have to be persuaded that the coupon is attractive enough, regulators have to be convinced, and shareholders have to be reassured that an useless dilution will be avoided. These conditions under which the conversion would take place compromise the fair value of the bond and are crucial to ensure the CoCoCos would achieve the intended objectives. 2.2.1 Mandatory Conversion

Under an hypothesis of a threatening situation, CoCoCos behave like standard CoCo bonds. They give the opportunity to stabilize the precarious equilibrium of the bank by using an automatic mechanism of conversion as soon as the bank fails to meet for example minimum regulatory capital levels. This is a the mandatory conversion. An important and ongoing discussion is the choice of the trigger event which sets o this emergency conversion. A second topic of a similar lively debate, is related to the conversion price of the shares which is the implied purchase price Cp of the shares when the trigger takes place. Trigger event The are dierent trigger events possible: - Accounting trigger: Balance sheet ratios are used to determine the nancial health of the nancial institution. A trigger event would correspond to such a ratio failing to meet a minimum level. An example are the Credit Suisse CoCos which convert into 6

shares when the core Tier 1 ratio drops below the minimum level of 7% and the CoCoCo issued by the Bank of Cyprus which would convert as soon as the core Tier 1 falls below 5%. - Market trigger: An observable parameter such as the level of the share price or the credit default swap spread of the bank could be used to trigger a conversion into shares or a write down of the bond. The market based trigger has not been used so far. - Regulatory trigger: This is also called a non-viability trigger and is actually pulled by the national regulator whenever this authority deems the situation of the bank to be fragile to survive. The CoCoCo issued by the Bank of Cyrpus has for example an extra regulatory trigger in addition to the accounting core Tier 1. Relevant is also the level of the trigger. A high trigger means that the bond is converted long before a dangerous threshold is reached. The trigger takes place when the bank is still a going-concern and the CoCo or CoCoCo are as a matter of fact tools to prevent the bank to slide in a more precarious situation. A low trigger on the other hand refers to an ultimate conversion just before a gone-concern or bank failure would be reached. The contingent convertibles are thus no longer prevention tools, they become an ultimate tool to reinforce a banks balance sheet. The conversion price The number of shares received upon a mandatory conversion is equal to the conversion ratio, CrMC . This is implicity related to another key element which is the conversion price, Cp , of the shares: CrMC = F , Cp (1)

where F is the face value of the bond. Several possibilities exist when it comes to the determination of the conversion price. Let us denote by t the time at which the CoCoCo bond is triggered (mandatory conversion):
- Cp = St = S(t ) One natural choice is to x the conversion price equal to the share price, St , observed on the trigger moment. Under this setting, the investor does not suer any loss at all because the total amount of the delivered shares is equal to the face value of the bond, F . For the shareholders, this leads to a signicant potential dilution of the equity because a large number of shares has to be distributed to the new owners. The lower the share price, the more

shares will created and the more dilution the exiting shareholder will have to undergo. - Cp = S0 = S(t0 ) The other option is to provide conversion into equity based on the share price, St0 , at the issue time. This has an opposite eect. The conversion price will typically be much higher than the real value of the stock at time t . The bond holder is forced to buy shares priced at Cp which is way above the value of the shares when a trigger takes place. This choice might be relatively generous to the shareholders not suering from a substantial dilution of their equity holdings.
- Cp = max(St , SF ) Another possibility is to combine the previous choices giving a compromise. The conversion price is set equal to the price at the conversion time but it is not allowed to drop below a oor value, SF .

2.2.2

Optional Conversion

When the solvency and the liquidity prole of a bank is distant from a distressed situation, the CoCo investor is dealing with the payo of a corporate bond. The CoCo holder cannot prot from any upside. The maximum payout is restricted to the face value and the coupons. The optional convertibility of the CoCoCo, on the other hand, gives the opportunity to the holder to participate on the upside and get a prot by converting the bond into shares. This is not a mandatory conversion, it is just a call option granted to the investor to terminate the bond and receive shares instead. The number of shares received per bond is the conversion rate, CrOC . The value of the shares received is the conversion value which is equal to CrOC St . We suppose that the option can be exercised over the life of the bond and the investor has to check daily if the optional conversion would be more protable than keeping the contract without an immediate exercise. When no immediate exercise takes place the value of the contract is the expected cash ow of the future payment, called continuation value P (t). The value of the CoCoCo bond at time t before expiration is thus the following: max(P (t), CrOC St ). (2)

At maturity, if the bond has not been converted, the CoCoCo investor still has the possibility to swap the total face value into shares leading the terminal value to be: max(F, CrOC ST ). (3)

Valuation of a CoCoCo bond

In this section we propose a pricing method able to handle jointly the optional and mandatory conversion. Both conversions depend on the path followed by the underlying share during the life of the bond and typically also apply to the expiration. The starting point is the generation of several stock paths for which the CoCoCo bond is evaluated. The consideration of trading in periods when the market can be followed by turbulent times calls for the stock price volatility to be stochastic. Due to the fact that the CoCoCo risk prole is characterized by a double convexity, we also do require a link between the stock price and the stochastic volatility: under changes of the stock price, the positive convexity leads the appreciation of the CoCoCo price to be bigger than a possible depreciation; the negative convexity presents the opposite behavior and the best solution for an investor would be to have a low volatility stock price. The Heston model allows us to incorporate the stochastic volatility and a non-gaussian distribution for the share price returns exhibiting fat tails. We combine this stochastic volatility model with a one-factor Hull-White model for the interest rate. Next, we proceed with the evaluation of the bond taking care of the mandatory conversion and of the optional conversion. The mandatory conversion for example used by the Bank of Cyprus was depending on an accounting trigger, the core Tier 1. Here, we work with a market trigger because it is not possible to model the core Tier 1 in a Monte Carlo simulation as already demonstrated in the literature (see Jan de Spiegeleer and Schoutens (2011a)): the core Tier 1 is in fact not observable nor can be traded or hedged. This means that the risk coming from it cannot be eliminated. The best solution is thus to model the mandatory conversion with respect to share price which without any doubt is well linked to the nancial health of the issuer. We make the assumption that as soon as the stock price falls below a certain trigger level corresponding to an emergency situation, the conversion in shares would take place.

3.1

Heston Model with stochastic interest rate

Moving away from Black-Scholes and using the Heston model, we assume that the stock follows a process with a stochastic volatility and a stochastic interest rate (Heston (1993)): dS(t) = r(t)S(t)dt + V (t)S(t)dWS (t) dV (t) = ( V (t))dt + V (t)dWV (t)

(4)

E(dWS (t)dWV (t)) = SV dt where S(t) and V (t) are the price and the variance processes, respectively, and WS and WV are correlated Brownian motions. The is the long term variance to which 9

the variance will revert through its mean reverting property. The is the rate of mean reversion which puts a constraint on how far the variance can drift away from the long-term variance. The is the volatility of the variance. The stochastic interest rate is driven by a Hull-White process (HW): dr(t) = ((t) ar(t))dt + dWr (t) E(dWr (t)dWS (t)) = rS dt E(dWr (t)dWV (t)) = rV dt Here a and are constants, (t) is deterministic and satises the following equation (Brigo and Mercurio (2006)): (t) = f M (0, t) 2 + af M (0, t) + (1 e2at ), T 2a (6) (5)

where f M is the market instantaneous forward rate. Let us denote the correlation matrix among the stock, variance, and interest rate by . Its positive deniteness is necessary for performing Monte Carlo simulations. 1 SV rS 1 rV = SV rS rV 1 3.1.1 Generation of stock paths

The valuation of a CoCoCo bond, will be implemented using Monte Carlo. To price a CoCoCo bond we have to use n Monte Carlo paths for the stock, for the variance, and for the interest rate. In order to practically generate one of them let us to introduce a nite time horizon [0, T ] sliced into m steps. Each step j has a T small time increments t = m and we set tj = jt. To take into account that the stock distributes some dividend payment along the life of the bond, we dene as Div the percentage dividend payment and as D the times of the dividend payments. We assume for simplicity that dividend payment always coincide with our points tj , j = 0, ..., m. At each step j the amount which has to be paid is the following: { Div if tj D, D(j) = 0 otherwise. According to the Equation 7, we simulate the ith stock path at step j using a Milstein discretization (Glasserman (2004)).

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S(i, j + 1) = S(i, j)(1 D(j))e(r(t)V (i,j))t+ V (i,j)tZS,i,j+1 V (i, j + 1) = V (i, j) + ( V (i, j))t + V (i, j)tZV,i,j+1 + t(ZV,i,j+1 1) 4 r(i, j + 1) = r(i, j) + ((j) ar(i, j))dt + tZr,i,j+1 (7) The ZS,i,j , ZV,i,j , and Zr,i,j are standard normal variables generated according to their correlations between the share price, the variance, and the interest rate and for example S(i, j + 1) denotes the stock price of the ith simulated path at time tj+1 . 3.1.2 Calibration of the model

The parameters, , , and of the stock price process, a, , and (t) of the interest rate process and the correlation matrix have to be calibrated according to the available market data (Brigo and Mercurio (2006)). We start nding out the values for the parameters in the interest rate model. (t) is estimated according to the Equation 6 exactly tting the observed term structure of the instantaneous forward rate, f M . The values for a and are determined via a calibration to a set of market prices for caps observed in the market: we minimize the root mean square error between the value of these contracts according to Black76 and the value of these contracts according to the the Hull White closed formula. After the determination of the stochastic interest rate dynamic, we proceed with the calibration of the Heston model. The common approach is to nd out those values for the parameters which produce the correct market prices of vanilla options: we minimize the root mean square error between the model price (closed formula available under Heston model) and the market price. The stock - interest rate correlation rS will be xed a priori and for simplicity we assume here that the interest rate is uncorrelated with the stochastic volatility (rV = 0).

3.2

Steps for pricing a CoCoCo bond

We now outline the steps for pricing a CoCoCo bond after the generation of 600, 000 stock paths. The value of a CoCoCo bond is equal to the expected cash ow at issue time. Let us dene CF (i, j) as the cash ow at step j for the ith path. Lets x the trigger level, S . We start selecting those paths in which the stock falls below S . For each of them we nd out the rst time step as soon as this happens. As example, Figure 3 illustrates three paths of our simulation with S = 50. The third path and the second one are above S overall the life of the bond. The Path 1 falls below S at time j . The mandatory conversion takes place, the

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bond stops to exists and from here on we are not longer interested in the behaviour of Path 1.
350 300

Path 3

Stock paths

250 200 150 100

Path 2 Path 1 Mandatory Conversion


1 2 j* 1 3 4 5

S* 50
0 0

Years

Figure 3: Example of three stock paths in our simulation

Step 0 Let us now introduce the following spaces: I = {path i: S(i, j) < S at some step j}. I c = {path i: S(i, j) S j}.

(8)

I is the set of paths for which the stock price falls below the trigger level and I c is the complementary. Step 1
For each path i I we select the earliest step ji for which the trigger sets o the conversion and we calculate the cash ow as equal to the amount of shares delivered to the investor after the conversion: ji = {rst step j for path i : S(i, ji ) < S }. CF (i, ji ) = CrMC S(i, ji )

(9) (10)

Step 2 For each path i I c , we calculate the cash ow at maturity (step m) as equal or to the bond face value increased by the nal coupon payments, or to the optional conversion value (see Equation 3): 12

CF (i, m) = max(F + Final Coupon, CrOC S(i, m)) Step 3

(11)

Starting from the time of maturity, we discount the cash ow with a backward induction and at each step we check if the optional conversion can be exercised. The approach will be dynamic because the number of paths will change as soon as the mandatory conversion appear. For example, in Figure 3 we observe that at maturity we have two cash ows: one for Path 3 and one for Path 2. As soon as we arrive at time j , we need to include in the backward process the cash ow coming from the mandatory conversion in Path 3: we need in fact to take into account the possibility of an optional conversion before the mandatory in j would take place. Let us suppose we are at step s with 0 < s < m 1. We dene the following spaces: J = {paths i: CrOC S(i, s) F } J c = {paths i: CrOC S(i, s) > F }

(12)

A rational investor will only convert when the option is in money, CrOC S(i, s) > F . For paths i J it does not apply so we discount the cash ow from the previous step according to the Equation 13: CF (i, s) = CF (i, s + 1)er(s+1)ts+1 for i J (13)

For the other paths i J c , the cash ow comes from max(P (i, s), CrOC Si,s ) (see Equation 2). We select the best strategy which provides the highest cash ow between exercising the optional conversion or continuing the contract. The evaluation of CrOC Si,s is straightforward because we exactly know the share value at step s from the stock simulation. To estimate instead the continuation value2 (P (i, s)) we make use of the Longsta Schwartz approach (Longsta and Schwartz (2001)) approximating the continuation value as a combination of basis functions:
m tk
tj

P (i, j) = E[

r(i,s)ds

CF (i, k)] (14)

k=j+1

==

L t=1

at lt (Si , Vi , ri )

2 We remind that the continuation value is the value of the contract if the option will not be immediately exercised.

13

where Si is the stock price for the ith path, at are constant coecients, and lt are the basis functions. In our model, the randomness comes from the share S, the stochastic volatility V , and the stochastic interest rate r. We have opted for using these three variables and their interactions up to the fourth power as basis functions: l(S, V, r) =[1 V r S r V r S V r SV S V 2 r2 S 2 V 3 r3 S V 2 S r2 V r2 S 3 r4 .. S V 3 S r3 V r3 S 2 V S 2 r V 2 r S V 2 r S 3 V V 3 r S 2 V 2 .. V 2 r2 .. (15) S 3 r S 2 r2 .. S 4 ..

V 4 ..

S V r2

S 2 V r ],

where S , V , and r have been normalized with respect to their initial values S0 , V0 , and r0 . According to the Longsta method, the coecients are estimated using a least square regression of the discounted CF (i, j) evaluated by Equation 13 on the basis functions li . Inside the regression we include all the paths i J c together. By substituting these coecient values into Equation 14 we get the estimated continuation value at time step j for all paths i J c . Summarizing, the cash payment at step s is: { CF (i, s + 1)er(s+1)ts+1 for i J (16) CF (i, s) = max(P (i, s), CrOC Si,s ) for i J c Step 4 Finally, we need to calculate the average, overall the Monte Carlo paths, of the discounted cash ow at issue time in order to get an estimate of the CoCoCo price.

Results and discussion

In this section we use a simplied CoCoCo structure (see Table 2) in order to apply the methodology outlined in Section 3. The CoCoCo bond has a 5-year maturity with a face value of 100. It distributes no coupon payments over time and no accrued interest is hence introduced. As soon as the share price falls below 50, a mandatory conversion takes place converting the bond in an amount of shares equal to 50 CrMC = 25. The CoCoCo bond holder has the right of exercising an optional conversion whenever it would be convenient for him, using a conversion rate CrOC of 0.5. 14

In order to get the price, we consider 600, 000 stock paths generated by Monte Carlo simulations 3 . The initial value of the share is S0 = 100 with an initial interest rate of 0.03 and an initial variance of 0.04. We set the correlation rS equal to 0.50, the correlation rV equal to zero, and we for simplicity use a at forward rate f M of 0.03. All the other parameters are obtained from the calibration of the Heston model and are provided in Table 3: equal to 0.100, equal to 0.040, equal to 0.200, and SV equal to 0.100 for the stochastic volatility; a equal to 0.010, and equal to 0.012 for the stochastic interest rate. CoCoCo bond Trigger Level 50 Maturity 5 years Face Value 100 Coupon CrMC 0.5 CrOC 0.5 Stock S0 r0 V0 rS rV fM Price 100 0.03 0.04 0.50 0.00 0.03

Table 2: Features of the CoCoCo prototype and of the stock price

Parameters of the model 0.100 0.040 0.200 SV 0.100 a 0.010 0.012 Table 3: Calibrated parameters for the Heston model with stochastic interest rate

4.1

Stochastic interest rate or constant interest rate?

Under this setting the price of the CoCoCo bond results to be 85.39. Do we really need to introduce a stochastic interest rate? The consensus in convertible bond pricing is to stick to deterministic interest rate. Brennan and Schwartz for example present a study (see Brennan and Schwartz (1980)) on convertible bonds and they argue that for a reasonable range of interest rate the errors of using deterministic instead of stochastic interest rates are likely to
To improve the Monte Carlo simulation we have also used the antithetical variable technique for the stock and the volatility.
3

15

be small and therefore for practical purpose it may be preferable to use deterministic rates which are simpler to simulate. In this section we advocate the use of uncertainty analysis. By using quasi random numbers, we generate 256 values for the volatility of the stochastic interest rate, in the Equation 5. For each of them, we run our algorithm in order to price the CoCoCo bond. Figure 4 illustrates how the CoCoCo price changes when varying the volatility of the interest rate.
90

85

CoCoCo Price

80

75

70

65

60

0.01

Volatility Interest Rate ( )

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.1

Figure 4: Variability of the CoCoCo price under changing of the interest rate volatility

The gure shows evident dispersion in the price whenever the volatility of the interest rate varies from 0% to 10%. The price ranges from 85 to 60. The volatility is here an important component when pricing CoCoCo bond. Lets now verify if the volatility is really of inuence in pricing CoCoCo and whether some other inputs play a relevant role. We thus investigate how much changes in the parameters of our quantitative model really aect the CoCoCo price in order to detect which ones are the most inuential when evaluating a CoCoCo bond. Several techniques can be applied which belong to the world of global sensitivity analysis. Among them we have decided to use the Saltellis variance based in order to quantify the contribution of each input parameter to the total uncertainty of the price. For details on this method we refer to Saltelli et al. (2004), Saltelli et al. (2008), Saltelli (2002), Saltelli et al. (2010), and Ratto and Pagano (2010). A typical output of the sensitivity analysis is a number called total sensitivity index which is able to detect how much the output varies due to changes of one input parameter considering its interaction with the other inputs. In our model the sources of uncertainty are the stochastic volatility and the stochastic interest rate whose dynamics are driven by Equation 4 and Equation 5.

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The rst one is depending on four parameters: , , , and SV . The second one4 is depending on four parameters: a, , and rS 5 . In Section 3 we have xed a priori rS and we have calibrated all the other parameters according to the market data (see Table 3). In this section, we let rS vary inside the range [1 1]; for all the other parameters we pick percentage variations of the calibrated values provided in Table 3. These percentage perturbations are selected using quasi random number in [1, 1] according to an uniform distribution. We use 256 percentage perturbation. This number has been demonstrated in Ratto and Pagano (2010) to produce valuable results in a general application of the variance based method. For each of them we price our CoCoCo bond according to the methodology presented in Section 3 and nally we calculate the sensitivity indices.

Figure 5: The most inuent parameters

Figure 5 illustrates how the volatility of the variance, , the interest rate-stock correlation, rS , and the volatility of the stochastic interest rate, , have the higher total sensitivity index values. The rst one does not come a surprise because we have already well explained how the use of the Heston model (stochastic volatility) is relevant when pricing an instrument with a double convexity. An interesting results is the importance of rS and . This tells us that the stochastic interest rate, through its correlation with the stock and its volatility parameter, is the rst responsible of the CoCoCo price variability. This numbers takes into account the
We remind that in our prototype we have chosen a zero volatility interest rate correlation and a at forward rate f M so that the parameter (t) results to be deterministic according to the Equation 6. 5 We remind that in our prototype we have chosen of setting the correlation rV equal to zero.
4

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individually contribution of r and the interaction eect among the others inputs. Hence, using a constant interest rate is absolutely not recommendable in the CoCoCo pricing, although it is a well practise in the convertible bond pricing. Although this introduces more complexity into the modeling, CoCoCos require a stochastic interest rate model.

4.2

Loss absorbing capacity of the bank

In this section we want to make clear and estimate the loss absorbing capacity of a CoCoCo when the issuer gets into a threatening situation. We thus focus on paths where a mandatory conversion takes place. We discount their cash ows and we make an average of them. The dierence between the face value and this average will provide us with an estimation of the loss absorbed as soon as a conversion takes place. For example, suppose that after a mandatory conversion, the amount of shares delivered to the investor is 80% of the face value. This means that 20% of the face value of the bond has been absorbed by the bank because it must not be delivered anymore. Table 4 highlights the relation between the price of a CoCoCo bond and its loss absorbing capacity which depends on the structure. Let us use a trigger level of 50; The upper part in Table 4 highlights how increasing the conversion ratio CrMC the price increases leading to decrease of the loss absorbing capacity of the CoCoCo bond. Increasing the conversion rate means that the investors will receives shares at higher price with less losses. Lower losses for investors translates into a lower absorption of losses from the issuer side. Now, let us x the CrMC and vary the trigger level: in this case Table 4 shows how the both price and loss absorbing capacity of the bond increase. Increasing the trigger level, the probability of a mandatory conversion increases so that the investor takes more risk investing in this bond. This well explains why the price decreases under this scenario. From the issuer side, an high trigger level is able to prevent a really dangerous situation but at the same time the capability of absorbing losses decreases because the conversion in shares takes place at high stock prices. The CoCoCo bonds are thus a kind of automatic reinforcement of the banks balance sheet but their success strictly depend on a trade-o between the interests of the investor and the interest of the issuer. The investor has to be persuaded that the price of the bond is fair enough and the issuer has to be convinced in the success of the loss absorbency of this instrument in crisis time.

Conclusion

In this paper, we have discussed a particular contingent convertible bond called, CoCoCo proposed by some nancial landscapes directed to save the banking system. Up to now, several conferences and debates have placed as core of the discussion the need of issuing debt instruments with loss absorption features. CoCoCo bonds fulll 18

CrMC 0.10 0.30 0.50 0.70 0.90 Trigger Level 10 30 50 70 90

CoCoCo Price 84.58 84.98 85.39 85.79 86.19 CoCoCo Price 88.43 88.00 85.39 76.83 58.78

Loss Absorbing Capacity 95.70 87.11 78.51 69.92 61.33 Loss Absorbing Capacity 95.89 87.47 78.51 68.78 57.88

Table 4: CoCoCo Price and Loss absorbing capacity of the CoCoCo bond when varying CrMC at S = 50 and varying S for CrMC = 50.

this requirement. They are loss absorbing in crisis time by means of a mandatory conversion of the debt into equity. At the same time they let investors to prot from the good performance of the shares by means of an optional conversion. In this paper, we have outlined the mechanism and the features of this novel bond and we have proposed a pricing methodology based on an American Monte Carlo simulation model under an assumption of stochastic volatility and stochastic interest rate. The paper makes clear in a qualitative and quantitative way that the volatility of the stochastic interest rate results to be an important component when pricing this debt instrument leading to the conclusion that pricing models based on constant interest rate are not really appropriate when dealing with this kind of instruments. Finally, we have quantied the loss absorbing capacity of this instrument and we have highlighted how the success of CoCoCo bonds is a really trade o between the interest of the investor and the interest of the issuer.

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