Enhanced Equity-Credit Modeling for Contingent Convertibles

Abstract

Contingent convertible (CoCo) bonds are characterized by forced equity conversion under either accounting or regulatory trigger. Accounting trigger occurs when the capital ratio of the issuing bank falls below some contractual threshold. Under the regulatory trigger, sometimes called the point-of-non-viability (PONV) trigger, the regulatory authority may enforce equity conversion when the financial health of the bank deteriorates to certain distressed level. In this paper, we propose an equity-credit modeling of the joint process of the stock price and capital ratio that integrates both the structural approach of accounting trigger and reduced form approach of PONV trigger of equity conversion. We also construct effective Fortet algorithms and finite difference schemes for numerical pricing of CoCo bonds under various forms of equity conversion payoff. The pricing properties of the CoCo bonds under different assumptions of the state dependent intensity of PONV trigger, contractual specifications and market conditions are examined.

Keywords: Contingent convertibles, equity-credit modeling, Fortet algorithms

JEL Classification: G13