Aspects and Dynamics of Contingent Convertible Bonds. Pricing Norwegian CoCo Issuances With Equity Derivative Approach

Abstract

Contingent convertible bonds have emerged as a going-concern loss-absorbing instrument in response to the last financial crisis. These hybrids, commenced by the new Basel III regulation, might be able to substitute the prevailing subordinated debt instruments that failed to effectively absorb losses during the last crisis. Issuing CoCos present an effective way to provide automatic recapitalizing for banks in times with financial distress, by forcing conversion to shares or automatic write-down when certain triggers are breached. Consequently, the instrument enhances robustness of the banking sector if constructed properly.

This thesis presents the structure and promising pricing methods of CoCos with Core Equity Tier 1 trigger, in which equity derivatives pricing method is found to be the most suitable. As the dynamics and structure of the instrument are complex, finding the appropriate trigger is not straightforward. Most of the existing models, including equity derivatives, imply high co-movement between Core Equity Tier 1 and stock prices in order to find the trigger level. However, as the historical correlation prove to be insignificant, there is need for new research in this field.

This thesis develop an modest attempt at finding the stock price trigger level based on an analytical approach using scenario CAPM β values. To test the analytical method in an equity derivatives approach, CoCo issuances by DNB in 2015 and 2016 are examined. The data is retrieved from TITLON financial database and company filings, whereas simple data handling is performed in Microsoft Excel. All computations are done in the statistical programming software R. The codes are available upon request. According to the best estimate, the price of both DNB CoCos are undervalued. As underpricing is apparent, the thesis points to several factors that may explain the discrepancy between theoretical and observed prices. These consists mainly of (1) mispricing caused by the model, and (2) mispricing due to market participants’ perception of CoCos dynamics.

Keywords: Contingent convertible bonds, Basel III, capital structure, regulatory capital, equity derivatives