Electronic copy available at: http://ssrn.

com/abstract=1971811
On Pricing Contingent Capital Notes

Dilip B. Madan
Robert H. Smith School of Business
University of Maryland
College Park, MD. 20742
Email: dbm@rhsmith.umd.edu
December 13, 2011
Abstract
A banks stock price is modeled as a call option on the spread of ran-
dom assets over random liabilities. The logarithm of assets and liabilities
are jointly modeled as driven by four variance gamma processes and this
model is estimated by calibrating to quoted equity options seen as com-
pound spread options. On dening riskweighted assets as asset value less
the bid price plus the ask price of liabilities less the liability value we
endogenize capital adequacy ratios following the methods of conic nance
for the bid and ask prices. All computations are illustrated on CSGN.VX,
ADRed into USD on March 29 2011.
1 Introduction
Contingent capital notes are a nancial innovation occuring in response to the
nancial crisis of 2008. The issuance of such securities was recommended by the
Squam Lake Report (2010) and the authors of this report encouraged regulators
to require nancial institutions to invest in regulatory hybrid securities. These
are long-term debt obligations converting automatically to equity in times of
nancial stress for the issuing entity. Such securities are seen as providing
avenues for automatic recapitalization in times of need (Due (2010)). A variety
of such notes are described in Madan and Schoutens (2011).
In November 2009, Lloyds Banking Group was the rst to issue such a secu-
rity. It was a Lower Tier 2 hybrid capital instrument called Enhanced Capital
Notes. They include a contingent capital feature with the notes converting to
ordinary shares if Lloyds published consolidated core Tier 1 ratio falls below
5%. In mid 2010 Rabobank issued a contingent core note and in October 2010, a

We thank Matthew Evans at Morgan Stanley for his encouragement on accomplishing the
analysis presented in this paper.
1
Electronic copy available at: http://ssrn.com/abstract=1971811
Swiss government-appointed panel, proposed the rst capital surcharge on too-
big-to-fail banks. Switzerlands biggest banks are to hold total capital equal to
at least 19 percent of their assets. By 2019, the lenders need to have a common
equity ratio of at least 10 percent and the rest in contingent capital. In response
to these requirements Credit Suisse announced in February 2011 the issuance
of CHF 6 billion trigger tier 1 CoCos called buer capital notes. Regulators
throughout Europe are expected to provide further clarity on the use of CoCo
bonds later this year. It is anticipated that the market for such securities could
grow to a trillion dollars in the coming years.
This activity has led to a demand for CoCo pricing models. There is a
potential loss on conversion that is linked to the value of the underlying stock
on the conversion date. However, the trigger for conversion is a balance sheet
entity like a tier one capital ratio. The components of this ratio are the value
of equity, the level of risk weighted assets and the add ons to be applied to
risky liabilities. Risk weighted assets are a measure of potential losses in asset
values while liability add ons assess the risk of having to unwind risky liabilities
unfavorably. We note in this regard the model with just risky assets that follow
a geometric Brownian motion process with a captial ratio trigger of equity to
asset values studied in Glasserman and Nouri (2010), that also accomodates
partial conversion.
In this paper we generalize the Merton (1974, 1977) approach and treat
equity as an option on the spread of risky assets over risky liabilities with a
strike determined at the level of debt less cash on hand and a maturity set in
the distant future. Equity options are then compound spread options and we
employ the surface of traded equity options to infer the joint law of risky assets
and liabilities. We then employ the methods of conic nance (Cherny and Madan
(2010)) that delivers models for bid and ask prices in two price economies. Risk
weighted assets are taken at the level of assets less a conservative bid price while
add ons are modeled by the ask price for liabilities less the value of liabilities.
The capital adequacy ratio is then determined endogeneously as the ratio of
equity values to the sum of risk weighted assets and liability add ons. We thus
have access to the joint stochastic process for the stock price and the capital ratio
that we employ to price the CoCo note. The pricing procedures are illustrated
on data for Credit Suisse.
The CoCo notes are USD dollar denominated while the underlying equity
option surfaces are in CHF. We therefore rst quanto the underlying option
surfaces into USD. The notes are however not quantoed and take the currency
risk at conversion. We therefore ADR (American Depository Receipt) the quan-
toed surface to build the surface for options on the dollar cost of foreign stocks
with dollar strikes. We then calibrate a synthetic dollar denominated asset and
liability process from the surface of CHF equity options ADRed into USD.
The specic model for the stochastic evolution of risky assets and liabilities
is a linear mixture of independent Lvy processes. We allow for the existence
of idiosyncratic shocks to assets and liabilities along with compensating and
compounding shocks that reduce assets and raise liabilities simultaneously. We
therefore employ four independent Lvy processes, two idiosyncratic, one com-
2
pensating and one compounding. The specic Lvy processes used are the
variance gamma model with three parameters for each of the four processes.
This yields a twelve parameter model for the joint law of assets and liabilities
that lies in the 1G class as dened in Kaishev (2010).
Once the asset and liability model has been calibrated to the USD ADRed
surface of CHF equity options, we price the CoCo by simulating the law of assets
and liabilities, pricing equity on this path space using a spread option model,
evaluating risk weighted assets and add ons by determining the bid price of
assets and the ask price of liabilities a year later. We then evaluate the capital
ratio and if a conversion is triggered we evaluate the loss on conversion. The
stress level for bid and ask prices is determined to match the initial or starting
reported capital ratio.
The steps in the procedure are
1. Calibrate the option surface in the foreign currency.
2. Calibrate the surface of FX options on CHF as a dollar denominated asset.
3. Quanto the surface into USD.
4. ADR the Quantoed surface to USD.
5. Calibrate the compound spread option model on equity option data for
the joint law of assets and liabilities.
6. Calibrate the conic stress level to the initial capital ratio.
7. Simulate time paths for assets, liabilities, stock prices and capital ratios.
8. Price the CoCo.
We present the details for each of these steps in separate sections with an
application to data on Credit Suisse. Though the trigger on the capital ratio is
7/ with a conversion stock price oored at 20 the market is trading closer to
the these triggers being at 6/ and 10 respectively.
2 The Foreign Equity Option Surface
The rst step is to parsimoniously represent the risk neutral distributions for
the stock price at all maturities with a few parameters. There are many option
pricing models one may use for this purpose and they include Lvy processes
(Schoutens (2003), Cont and Tankov (2004)), stochastic volatility models (He-
ston (1993), Carr, Geman, Madan and Yor (2003)) with and without jumps
and Sato processes (Carr, Geman, Madan and Yor (2007)). Lvy processes are
particularly suited to options at a single maturity but as theoretically excess
kurtosis and skewness decrease like the reciprocal of maturity and its square
root respectively, while in data they are relatively constant, these models do
not provide a good synthesis when multiple maturities are involved (Konikov
3
and Madan (2002)). Stochastic volatility models on the other hand introduce
the complexity of a second stochastic dimension for volatility when we already
know that in the absence of static arbitrage, option prices must be consistent
with a one dimensional Markovian model (Carr and Madan (2005), Davis and
Hobson (2007)). The Sato process provides us with a particularly simple four
parameter model capable of synthesizing option prices at a point of time across
both strike and maturity. We employ here the Sato process based on the vari-
ance gamma law at unit time (Madan and Seneta (1990), Madan, Carr and
Chang (1998)).
Let G be a gamma variate with unit mean, variance i and density
)(q) =
_
1
i
_1

q
1

1
c

I
_
1
i
_ , q 0.
The variance gamma variate A is the law of
A = 0Go
p
G7
where 7 is a standard normal variate independent of G. The law for A is
innitely divisible with characteristic function
1
_
c
Iu

=
_
1
1 in0i
c
2
i
2
n
2
_1

.
The Lvy process associated with A is a pure jump process with Lvy measure
/(r)dr =
1
i
oxp
_
0r
c
2
1jrj
_
jrj
dr,
1 =
1
o
_
_
2
i

0
2
o
2
_
.
The variance gamma law is also a self decomposable law as is evidenced by
observing that jrj/(r) is decreasing in r for r 0 and increasing in r for r < 0.
Sato (1991) showed that one may associate with any self decomposable law and
additive process with marginal distributions for A(t) the law of the process at
time obtained by scaling the unit time law A whereby
A(t)
(J)
= t
~
A.
The Sato process associated with the variance gamma law then has four parameters,o, i, 0
and .
The stock price at time t, o(t) is risk neutrally modeled as
o(t) = o(0) oxp((r ) t A(t) .(t)) ,
for an interest rate of r, a dividend yield of and a convexity correction .(t)
dened by
.(t) = log 1 [oxp(A(t))[ .
4
The characteristic function for the logartihm of the stock price is easily obtained
in closed form and option prices may then be computed using Fourier inversion
as described in Carr and Madan (1999).
We take the surface for Credit Suisse as quoted in Zurich, CoG.\ A on
March 29 2011. The number of options is 160 across 11 maturities and we
present a graph of the actual option prices in Figure 1 along with the actual
and tted prices in Figure 2. The parameter estimates for the variance gamma
Sato process and t statistics of the root mean squared error (r::c) the average
absolute error (aac) and the average percentage error (ajc) are
o = 0.2680
i = 0.2022
0 = 0.2880
= 0.627
r::c = 0.14
aac = 0.1046
ajc = 0.0611
3 The FX Option surface
In order to Quanto and ADR a surface from CHF into USD we also need the
risk neutral law of the USD quoted in CHF. For this purpose we also t the Sato
process based on the variance gamma law to these FX options. The parameter
estimates for this t on March 29 2011 were
o = .1208
i = .110
0 = .024
= .224
The t statistics were r::c = .000648, aac = .000488, and ajc = .081.
4 Quantoing CSGN.VX from CHF to USD
We rst explain in a subsection the general procedure employed for quantoing an
option surface from one currency into another. This requires the specication of
a joint risk neutral law for the stock and the currency with risk neutral marginals
as already estimated by our Sato process associated with the variance gamma
law at unit time. A separate subsection details the joint law employed. A third
subsection applies these methods to construct the quantoed surface that we
ADR in the next section.
5
20 25 30 35 40 45 50 55 60
0
2
4
6
8
10
12
strike
O
p
t
i
o
n

P
r
i
c
e
csgn on 20110329
T=4.7260
T=3.7288
T=2.7315
T=2.2329
T=1.7342
T=1.2164
T=0.7178
T=0.9671
T=0.4685
T=0.2192 T=0.1425
Figure 1: 169 Option Prices at 11 maturities for CSGN on March 29 2011.
6
20 25 30 35 40 45 50 55 60
-2
0
2
4
6
8
10
12
actual and fitted prices for csgn on 20110329
stri ke
o
p
t
i
o
n

p
r
i
c
e
Figure 2: Actual prices in circles with tted prices in dots of the same color for
matching maturities.
7
4.1 General Principles for Quantoing Option Surfaces
We wish to quanto a foreign asset with foreign price o with foreign exchange
rate 1 in foreign currency per dollar into dollars. We assume the existence of
a foreign risk neutral joint law, w(o, 1) that prices all joint claims on (o, 1) in
foreign currency by pricing c(o, 1) at
n = c
:
F
T
_
1
0
_
1
0
c(o, 1)w(o, 1)dod1.
We now dene the exchange rate the other way around by = 1
1
that
is a dollar denominated asset and consider the issuance of quantoed securities
paying c(o, ) in dollars. The initial values for the exchange rates for the two
directions as
0
, 1
0
. The quantoed joint risk neutral law 1(o, ) prices this
claim in dollars at
n = c
:
D
T
_
1
0
_
1
0
c(o, )1(o, )dod.
The price n is in foreign currency while n is a dollar price.
We may hedge c(o, ) by buying c(o, 1) in the foreign market and dening
c(o, 1) such that
c(o, ) = c
_
o,
1

_
,
c(o, 1) = 1c
_
o,
1
1
_
.
The cost of this in foreign currency is
n = c
:
F
T
_
1
0
_
1
0
c(o, 1)w(o, 1)dod1
= c
:
F
T
_
1
0
_
1
0
1c
_
o,
1
1
_
w(o, 1)dod1.
and the dollar cost is
n =
0
c
:
F
T
_
1
0
_
1
0
1c
_
o,
1
1
_
w(o, 1)dod1.
We now write this in the desired form to identify 1(o, ). We write
n = c
:
D
T

0
c
(:
D
:
F
)T
_
1
0
_
1
0
1c
_
o,
1
1
_
w(o, 1)dod1
= c
:
D
T

0
c
(:
D
:
F
)T
_
1
0
_
1
0
1

3
c (o, ) w
_
o,
1

_
dod.
It follows that
1(o, ) =
0
c
(:
D
:
F
)T
1

3
w
_
o,
1

_
.
8
We verify that we have a joint density as
_
1
0
_
1
0
1(o, )dod =
_
1
0
_
1
0

0
c
(:
D
:
F
)T
1

3
w
_
o,
1

_
dod
=
0
c
(:
D
:
F
)T
_
1
0
_
1
0
1w(o, 1)dod1
=
0
c
(:
D
:
F
)T
1
0
c
(:
F
:
D
)T
= 1.
The quantoed marginal is
H(o) =
_
1
0
1(o, )d
=
0
c
(:
D
:
F
)T
_
1
0
1

3
w
_
o,
1

_
d
=
0
c
(:
D
:
F
)T
_
1
0
1w(o, 1)d1
=
_
1
0
1w(o, 1)d1
1
0
c
(:
F
:
D
)T
.
4.2 The joint law employed
At each maturity we have the marginal law for both the logarithm of the stock
and the currency as a variance gamma law. We may write the logarithm for the
stock in the form
: = :
0
(r
J
)t .
s
0
s
q
s
o
s
p
q
s
7
s
.
We may also write similarly for the logarithm of the exchange rate quoted as
CHF per USD that
r = r
0
(r
J
r
1
)t .
r
0
r
q
r
o
r
p
q
r
7
r
.
If we wish to price the quanto option by just correlating the Brownian motions
we simulate :, r on the above joint law with correlation j between 7
s
and 7
r
.
For a call option with strike 1 we average
c
:
D
|
(c
s
1)
+
c
.x+0xx+cx
p
x2x
,
where the martingale in the exchange rate now serves as a measure change that
reweights the paths. Given vgssd parameters for the logarithm of the stock
and the logarithm of the exchange rate along with a correlation value we may
construct this quanto surface.
We have a few options in building the joint law given the two marginals.
We may correlate the Brownian motions. We may also correlate the gamma
processes. Basically the marginal gammas are obtained in terms of standard
9
gammas or the law of a unit scale standard gamma process (t) simulated at
(i
s
) for q
s
and an independent gamma process taken at (i
r
) for q
r
.
Apart from correlating the gammas we can build a copula for the joint law
for the two marginal martingales
'
s
= oxp(.
s
0
s
q
s
o
s
p
q
s
7
s
) ,
'
r
= oxp(.
r
0
r
q
r
o
r
p
q
r
7
r
),
as
C(1
1s
('
s
), 1
1x
('
r
)).
In particular one could sample
'
s
= 1
1
1s
((7
s
)),
'
r
= 1
1
1x
((7
r
)),
for correlated 7
s
, 7
r
.
In the current implementation we merely correlate the Brownian motions
to build a quanto surface. As an input we then require a term structure of
correlations that species the correlation between the standard normal variates
to be employed at each maturity. In our example we have just used a at
correlation.
4.3 Quantoing CSGN.VX into USD
We employed a at correlation of 1/ at each maturity to build the surface of
quantoed option prices. The 160 options on the Zurich exchange were quantoed
into USD using the joint law based on correlating the normal variates. Figure
3 presents the data on these quantoed option prices.
5 ADR the Quantoed Surface
We present rst in a subsection a general procedure for how we ADR a surface.
The next subsection presents the results on CSGN ADRed into USD.
5.1 General Procedure to ADR a surface
Let 1 = o where o is the quantoed asset and is the currency as lo1 per
CH1. We may build the joint law of 1, from the joint law of o, and here
we must have and will show that we do have the monotonicity in convex order
for the joint law on (1, ). Let this joint density be A(1, ). By the change of
variables we get that
A(1, ) = 1
_
1

,
_
1

=
1

4
w
_
1

,
1

_
.
10
20 25 30 35 40 45 50 55 60 65
0
2
4
6
8
10
12
Dollar Strike
O
p
t
i
o
n

P
r
i
c
e
csgn quantoed i nto usd at flat 15% correl ati on
Figure 3: CSGN 169 options at 11 maturities quantoed into usd at at 15%
correlation
11
Consider now a convex function c(1, ) and the expectation
_
1
0
_
1
0
c(1, )A(1, )d1 d =
_
1
0
_
1
0
c(1, )
1

4
w
_
1

,
1

_
d1 d
=
_
1
0
_
1
0
c(
o
1
,
1
1
)1w(o, 1)dod1,
on making the change of variables
o =
1

,
1 =
1

.
We now show that for any convex function c(1, ) the function (o, 1) =
c
_
S
1
,
1
1
_
1 is convex. This short proof was communicated by Marc Yor. Con-
sider and two martingales ', and note that by convexity of c, c(', ) is
increasing in expectation. Now change measure to Q using the martingale .
Under Q, the pair of processes
_
1

,
1

_
are martingales. Hence under Q the
expectation of c
_
1

,
1

_
is increasing in expectation. It follows that under the
original probability c
_
1

,
1

_
is increasing in expectation or the expectation
of (', ) is increasing in expectation for all martingales. Now take ', to
be continuous martingales driven by correlated Brownian motions with constant
volatilities and correlations, apply Itos lemma and deduce that is a convex
function. So the implied joint surface of the 11 and the exchange rate is
increasing in the convex order.
To build the ADR surface we price options as
c
:
D
|
_
1
0
_
1
0
(1 1)
+
A(1, )d1 d
= c
:
D
|
_
1
0
_
1
0
(1 1)
+
1

4
w
_
1

,
1

_
d1 d
= c
:
D
|
_
1
0
_
1
0
_
o
1
1
_
+
1w(o, 1)dod1
= c
:
D
|
1
_
_
S
1
1
_
+
1
_
1
0
c
(:
F
:
D
)|
.
so from a joint distribution of o, 1 we simulate the above expectation to deter-
mine the 11 surface.
5.2 CSGN.VX ADR into USD
We employed the procedure described in the section 5.1 to ADR the surface of
CSGN.VX as quoted in Zurich into USD. Figure 4 presents the prices of all 160
options after they have been ADRed into USD.
12
20 25 30 35 40 45 50 55 60 65
0
2
4
6
8
10
12
strike
o
p
t
i
o
n

p
r
i
c
e
csgn adr into usd
Figure 4: CSGN 169 options at 11 maturities ADRed into usd at at 15%
correlation
13
6 The Compound Spread Option Model for the
law of the balance sheet
We present in a subsection the theoretical model for equity options as a com-
pound option on the spread of assets over liabilities with a strike given by a
debt face value of 1 less cash reserves of ' and a distant maturity. The re-
sults of calibrating this model on the surface of CSGN.VX ADRed into USD is
presented in a following subsection.
6.1 Equity Options as Compound Spread Options
The risk neutral law of (T) 1(T) may be modeled as the dierence of two
exponential Lvy processes that we may simulate forward in time. On this path
space we may evaluate the path space of equity prices computed as a spread
option with an expected payo under a risk neutral t conditional expectation
operator 1
|
as
J(t) = 1
|
_
((T) 1(T) (1 '))
+
_
. (1)
The spread option computation is a two dimensional Fourier inversion that
integrates out the random elements in the asstes and liabilities. We employ
for the purpose the algorithm proposed by Hurd and Zhou (2009). The path
space of assets and liabilities is transformed into a path space of equity prices
upon applying the spread option computation at the various levels of assets
and liabilities reached at time t in the asset liability simulation. This equity
price path space is then used to construct equity option prices for strike 1 and
maturity t by averaging over the path space to estimate the equity option value
reported in the ADR surface as
n(1, t) = c
:|
1
_
(J(t) 1)
+
_
.
We determine the parameters of the joint and correlated risky asset and liability
value process to best t the surface of the equity option surface as seen on the
ADR surface.
We take the risk neutral risky asset and the risky liability as exponential
Lvy processes with
(t) = (0) oxp(A(t) (r .

)t) ,
1(t) = 1(0) oxp(1 (t) (r .
Y
)t) ,
where we now allow for a rich dependence in these processes. If we take a linear
mixture of just two independent Lvy processes we get jumps occurring on two
rays from the origin. If the independent processes are variance gamma \ G
processes for example then we have a variance gamma process running in log
space on a particular ray from the origin with the asymmetry parameter on this
ray being the skewness parameter of this particular variance gamma process.
14
Given that we operate in a two sided way for each independent Lvy process,
we need to cover 180 degrees of possible directions of motion. We take 4 variance
gamma processes with 12 parameters placed at the degrees 0, 4, 00, and 18.
This gives us two idiosyncratic rays at the angles of 0 and 00 where assets and
liabilities are independently aected. The angle of 4 allows for compensating
eects with assets and liabilities moving together while the angle 18 allows for
compounding eects on the two sides of the balance sheet.
We shall let the calibration determine the relative variance placed on each
of the four rays. For the four angles j

, , = 1, 4, we have the jumps in assets

and liabilities as
r

= n

cos(j

),
j
I
= n

sin(j

),
where n
I
is the jump in the ,
||
\ G process with parameters o

, i

, 0

. We then
have that
_
A(t)
1 (t)
_
=
_
cos(j
1
) cos(j
2
) cos(j
3
) cos(j
4
)
sin(j
1
) sin(j
2
) sin(j
3
) sin(j
4
)
_
_

_
l
1
(t)
l
2
(t)
l
3
(t)
l
4
(t)
_

_
,
and our joint law is the linear mixture of 4 independent \ G Lvy processes with
a prespecied mixing matrix. The joint characteristic function is
1 [oxp(inA(t) i1 (t))[ =
4

=1
_
_
1
1 i(ncos(j

) sin(j

))0

c
2
j
ij
2
(ncos(j

) sin(j

))
2
_
_
t

j
= c(n, ).
The value of
.

=
4

=1
1
i

ln
_
1 cos(j

)0

o
2

cos
2
(j

)
2
_
,
.
Y
=
4

=1
1
i

ln
_
1 sin(j

)0

o
2

sin
2
(j

)
2
_
,
and the characteristic function of the logarithm of assets and liabilities is
1
_
c
Iuln(.(|))+Iu ln(J(|))
_
= c(n, ) oxp(inln((0))i ln(1(0))in(r.

)ti(r.
Y
)t).
Our equity value at any date t given a simulation of (t), 1(t) is the price
of a spread option with some strike and maturity using this joint characteristic
function with initial values (t), 1(t) and time to maturity T t. For the initial
value of risky assets and risky liabilities excluding debt, we take these magni-
tudes from the balance sheet but permit some option market adjustment factor
15
to match the stock price. The adjustment factor is calibrated by equating the
value of equity computed as a spread option at the strike of debt less initial cash
equivalent reserves with the initial stock price at market close on the calibration
date.
6.2 Results of Calibrating Compound Spread Option Model
on the ADR surface
We estimated the asset and liability process from ADRed equity options seen as
compound spread options. The assets and liabilities are linear mixtures of four
independent variance gamma processes running on the angles 0, 4, 00, 18. The
estimated parameter values for the ADR surface with 160 options are as given
in Table 1.
TABLE 1
Results of Calibrating
Compound Spread
Option Model
Parameter Value
o(0) 0.017
i(0) 0.0826
0(0) 0.0700
o(4) 0.0088
i(4) 0.0804
0(4) 0.1700
o(00) 0.2287
i(00) 0.1888
0(00) 0.240
o(18) 0.0800
i(18) 0.040
0(18) 0.1412
We present a graph in Figure 5 a graph of the t of this compound spread
option model to the ADR surface.
We have not converged in this calibration but we stopped at 200 function
evaluations. The t is quite good for some of the intermediate maturities but the
longer maturities are not that well calibrated. We are aware of the limitations of
a Lvy model with regard to tting a full surface (Konikov and Madan (2002)).
As an additional check on the convergence we computed the left and right
derivatives at the calibration point and these are reported in Table 2. Most of
these, excepting 0(0), 0(4), are negative and positive as they should be for a
local minimum. We accepted this calibration for our subsequent analysis of the
16
20 25 30 35 40 45 50 55 60 65
0
2
4
6
8
10
12
Strike
O
p
t
i
o
n

P
r
i
c
e
Compound 4 VG Mixture Spread Opti on Model Cali bration to CSGN.VX ADRed into USD
Figure 5: Calibration of Compound Spread Option Model with Assets and
Liabilities as a linear mixture of four independent VG processes. Data in circles.
17
CoCo as reported in the remaining sections.
TABLE 2
LEFT RIGHT GRADIENTS
LEFT RIGHT
o(0) 0.4701 0.0888
i(0) 1.068 0.171
0(0) 0.0000 0.020
o(4) 0.081 0.0880
i(4) 0.0864 0.642
0(4) 0.2110 0.0864
o(00) 2.0140 4.7086
i(00) 0.0488 0.2870
0(00) 0.1822 0.21
o(18) 2.007 0.8011
i(18) 0.864 0.0486
0(18) 0.087 0.0288
7 Calibrate the Conic Stress Level
For the capital adequacy ratio (C1) we need to construct risk weighted assets.
For this purpose we simulate assets and liabilities out one year and we then
dene risk weighted assets as the loss on an unfavorable unwind of assets and
liabilities. This is computed as asset value less the bid price of assets one year
later plus the ask price of liabilities one year later less the liability. We may
write this as
1\
|
=
|
/(
|+1
) a(1
|+1
) 1
|
. (2)
The bid and ask prices are computed by concave distortions using the dis-
tortion :i::arar whereby
w
~
(n) = 1 (1 n
1
1+
)
1+~
,
and the bid price of a random outcome A with distribution function 1(r) for
positive A is given by
/(A) =
_
1
0
rdw
~
(1(r)),
while the ask price is
a(A) = /(A).
In greater detail given the joint law of assets and liabilities one may simulate
paths of (t
I
), 1
I
(t
I
), forward in time quarterly for 18 years for quarters i =
1, , 2, and t
I
= i/, with / = 2, from initial dollar values per share reported
in the balance sheet. The per share initial dollar value of assets was 1066.84
while the per share dollar value of liabilities was 088.2. The strike per share
of debt less cash was 22.70 with a stock price of 42.08. We may then apply
18
our spread option computation to transform the level of assets and liabilities
attained to equity values J(t
I
).
For any level of assets (t
I
) and liabilities 1(t
I
) attained at any time point
t
I
we may further simulate assets and liabilities forward from these levels by one
year to get readings
|i+1,
, 1
|i+1,
for , = 1, , . We then evaluate the bid
price of assets as a distorted expectation of
|i+1,
on arranging the readings
in increasing order
|i+1,()
with the bid price being
/
~
|i
=

|i+1,()
_
w
~
_
,

_
w
~
_
, 1

__
.
Similarly we determine the ask price for liabilities a
~
|i
as the negative of the bid
price for 1
|i+1,
.
The distortion w
~
(n) employed here is minmaxvar and we model the level
of risk weighted assets as per equation (2).
The equity price J(t
I
) is determined by applying the spread option model
(1) and the capital adequacy ratio is computed as
C1
|i
=
J(t
I
)
1\
~
|i
.
The value of was estimated at 0.42 to calibrate the reported an initial capital
ratio of 18.82/.
8 Simulating assets, liabilities, stock prices and
capital ratios
We now hold the stress level xed at the initial calibration point and simulate
the paths for assets, liabilities, stock prices and capital ratios. We present in
Figure 6 a graph of the stock price against the capital ratio at six year ends.
We observe that the relationship is nonlinear. The relationship is closer to
linear on a log log plot as shown in Figure 7.
We regressed the logarithm of the stock price against the logarithm of the
capital adequacy ratio at each quarter end. The results of the regressions are
available a spreadsheet. The average relationship between the stock price and
the capital adequacy ratio is
o = 11.711 (C1)
0.6102
oxp
_
.186 .
.0848
2
_
,
for a standard normal variate .. The conditional volatility of the stock given
C1 in this model is
11.711 (C1)
0.6102
oxp
_
.0848
2
_
,
and this rises with the level of the C1.
19
Figure 6: Graph of the stock price against the capital ratio at six year ends.
20
Figure 7: Log Stock vs Log capital ratio at six year ends
21
We may run the regression the other way to get
C1 = .000872 o
1.5615
oxp
_
.2048.
.2048
2
2
_
.
One could use such a dependence in modeling the CoCo conversion and
periodically we may revise the dependence.
9 Pricing the CoCo
We simulate 100000 paths of assets and liabilities each quarter for 18 years and
convert these to stock prices via the spread option calculator. We also use a
stress level of 0.42 and a starting value of C1 of 18.82/ and simulate risk
weighted assets quarterly for 18 years.
The loss is modeled on a conversion occuring the rst time both
C1 < C and otoc/ 1ricc < o.
We then evaluate the present value of the loss for a number of values of o, C.
The present value of the loss |(t) at time t is given by
|(t) = 1
c.1<c
_
100
100
o(t) _ o
o(t)
_
c
:|
.
The results are presented in Table 3.
TABLE 3
CoCo Present Value of Losses on Conversion
Ca|nc:
o\ a|nc: .0 .0 .06 .06 .07
17 14.4 14.22 14.08 14 18.0
18 12.7 12.88 12.12 11.07 11.87
10 11.0 10.40 10.08 0.82 0.64
20 0.48 8.61 8.02 7.62 7.8
21 8.17 7.08 6.80 .78 .88
22 7.4 6.14 .20 4.7 4.10
28 7.00 .0 4.8 8.81 8.28
24 6.00 .20 4.12 8.88 2.7
2 6.82 .14 8.80 8.08 2.41
Though the quoted trigger levels are 7/ for the C1 and 20 for the stock
the market trades closer to the trigger of 6/ on C1 and 10 for the stock.
10 Conclusion
A model is constructed for the stock price of bank as a call option on the
spread of random assets over random liabilities with a strike set at debt less
22
cash equivalents and a distant maturity. The logarithm of assets and liabilities
are jointly modeled as driven by four variance gamma processes, two of which
are idiosyncratic, one is compensating while the other is compounding in their
shock eects. The joint law is estimated by calibrating this law to quoted equity
options that are seen as compound spread options. Once the law is calibrated
it may be simulated for the time paths of assets and liabilities and the resulting
stock prices seen as a spread option. Additionally we simulate at all times
the random assets and liabilities out by one year to evaluate their riskiness by
evaluating bid and ask prices for the assets and liabilities respectively. Dening
riskweighted assets as asset value less the bid price plus the ask price of liabilities
less the liability value we endogenize capital adequacy ratios. The resulting path
space allows for an assessment of conversion losses on securities like CoCos
that trigger a stock priced based loss contingent on a capital ratio event. A
number of such securities are issued as dollar denominated on European and
Swiss underliers. Procedures are also developed for quantoing and ADRing
foreign equity option surfaces into USD before estimating the compound spread
option model driven by four independent variance gamma processes.
All computations are illustrated on CSGN.VX, ADRed into USD on March
29 2011. We nd that the market trades the Credit Suisse CoCo at a capital
ratio trigger strike at 6/ with the stock oor at 10 with listed strike and oor
being 7/ and 20.
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