Less obvious impediment of calibration approach which can be potentially mitigated is

interconnectedness of assumed trigger level and implied volatility, both being inputs to pricing
formula. Going beyong Black Scholes mechanics and constant volatility assumption presents the
need to incorporate smile and therefore requires using different level of volatility for different
assumed trigger level. This furher hinders calibration process as the relationship between trigger
level and volatility has to be assumed implied volatilities are not available for all potential strikes
(trigger levels), but rather there is only a small set of implied volatilities for several strikes and
maturities. In practice, set of observed volatilities is used to calibrate volatility model and than use
the model with fitted parameters to obtain implied volatilities for the missing strikes e.g. implied
trigger level. Not to overcomplicate matters and obfuscate the calibration approach by using two
simultaneous calibrations one for volatility surface and second one for finding implied trigger level,
function form for volatility as in Gatheral is assumed further in the thesis when calibrating the
implied stock trigger value. This closed end form for volatility smile ensures that also volatility smile
is taken into account, while maintaining stock price the only parameter needed to be calibrated to
get to observed CoCo price/spread.

3.2 Equity derivatives model

Equity derivatives model looks at the contingent convertibles from other perspective, splitting its
payoff conditioned on the occurrence of trigger event. If trigger event does not occur before the
maturity of contingent convertible, CoCo behaves as a corporate bond. The value can be computed
as a discounted stream of cashflows:

= =1 . . + . . (1)

The case of occurrence of trigger event is then modeled as knock in forwards with a purchase price
of each share equal to contractually specified conversion price . Knock in forward is the forward
instrument, which is only exercised when preset limit is breached. This limit is in case of contingent
convertible the stock price level associated with the CoCo trigger specified in the contract this
again, same as with credit derivatives model, leads to great degree of arbitrariness. For chosen
trigger level, value of knock in forward can be calculated using put call parity

= (2)

Value of knock in call and knock in put can be, assuming Brownian motion of stock price as in
Black Scholes model calculated as:

2 2
2(+ ) 2( )
2 2
2 2
= . . . ( ) . (1 ) . . . ( ) . (2 ) (3)

= . . . (3 ) . . . (4 ) (4)

Where
 2
( )+(+ ).
2
1 = .
2 = 1 .
2
( )+(+ ).
2
4 = 3 = 4 .
.

Value of a coupon leg of a contingent convertible needs additional adjustment reflecting the
possibility of trigger event, in which case coupon payments stop. This reduces the value of bond
expressed in equation (1). For each coupon short position in a binary down-and-in option must be
added to the value of CoCo derived so far. Knock in, which corresponds to occurence of trigger event,
eliminates the coupon. Value of a single Binary down and in option on coupon can be calculated
using equation below:

= . . . [(] (5)

Final value of contingent convertible bond is the sum of three legs:

= + (6)

More detailed derivation of formulas above can be found for example in Pricing Contingent
Convertibles: A Derivatives Approach (De Spielgeer & Shoutens, 2011). For the purpose of this thesis,
it is important to note that again the same variables, together with known cash flows, are required
for the calculation of CoCo value. Moreover, the same simplifying step of associating trigger event
with particular stock price is necessary for the calculation. Also, both credit derivatives and equity
derivatives models rely on Black Scholes pricing framework, assuming constant volatility.