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Pricing and Hedging CoCos

Patrick Cheridito

ORFE and Bendheim Center for Finance


Princeton University
Princeton, NJ 08544, USA
Zhikai Xu
ORFE
Princeton University
Princeton, NJ 08544, USA
First version: February 1, 2013
Current version: June 14, 2013
Abstract
Contingent convertible bonds are typical hybrid products in that they are exposed to dierent
sources of risk: interest rate risk, equity risk and conversion risk. We develop a general framework for
their pricing and hedging that can be specied in dierent ways. We focus on structural and reduced
form models driven by a nite-dimensional Markov process. The two approaches are qualitatively
dierent. But both allow to price contingent convertibles and calculate dynamic hedging strategies
with holdings in related instruments such as xed income products, the issuing companys stock and
credit default swaps. As case studies we consider contingent convertibles issued by Lloyds Banking
Group in December of 2009 and Rabobank in March of 2010. Both modeling approaches suggest that
on Oct 14, 2011, the contingent convertibles of Lloyds Banking Group traded at a price that was low
relative to market quotes of interest rate swaps, the rms equity and credit default swaps, while they
produced prices for the Rabobank contingent convertibles that were close to their market value.
Keywords: Contingent convertible bonds, credit default swaps, pricing, calibration, hedging, struc-
tural model, reduced form model.
1 Introduction
A typical contingent convertible bond (CoCo) is a corporate bond that converts into equity of the issuing
rm if a prespecied trigger event occurs. However, there exist dierent variants. Some convert into a cash
payment (write-down), and others just become worthless (write-o). Motivations for issuing CoCos vary.
But since the nancial crisis of 20072009 they have been oered by a number of nancial institutions
to protect their capital buers in times of crisis. For instance, they have been issued by Lloyds Banking
Group, Rabobank, Credit Suisse, Bank of Cyprus, Australia and New Zealand Banking Group, UBS,
Z urcher Kantonalbank and Macquarie. The purpose of this paper is to develop a theoretical framework
for the pricing, calibration and hedging of CoCos from the point of view of a market participant. A CoCo
is specied by the following three characteristics:
Maturity, principal and coupons. Like a standard corporate bond, a CoCo promises to make coupon
payments and redeem the principal at maturity. The coupon rate can be xed or oating.

We thank Frederic Abergel, Markus Brunnermeier, Agostino Capponi, Frederic Samama, Taha Vural and Alexander
Wugalter for helpful comments.

Partially supported by NSF Grant DMS-0642361


1
A trigger event causing the CoCo to convert. Dierent trigger mechanisms are possible. Accounting
triggers are based on accounting measures of capital adequacy. Market triggers are set o by market
events such as declines in stock prices or indexes. Regulatory triggers allow regulators to impose
conversion on rms in nancial distress. Decision triggers leave it to the rms management to
decide when to convert the CoCo.
A conversion mechanism describing what happens when the trigger event occurs. A typical CoCo
converts into a prespecied number of equity shares. Write-down CoCos lose part of their principal,
and write-o CoCos become worthless. Normally, a CoCo also pays accrued interest at conversion.
Most existing CoCos have an accounting trigger. Some have an additional regulatory trigger. Others
are callable by the issuer, and some include an option for the holder to convert the CoCo early. As case
studies we focus on issuances by Lloyds Banking Group in December of 2009 and Rabobank in March of
2010. Lloyds Banking Group issued dierent CoCos at the end of the year 2009. We consider one that
was issued on the 1st of December with a maturity of 10 years. It makes xed coupon payments and
converts into a prespecied number of common equity shares if the Core Tier 1 Ratio of Lloyds Banking
Group falls below 5%. The Rabo CoCo was issued on March 19, 2010 with a maturity of 10 years and
xed coupon payments. Rabobank is a cooperative society without publicly traded stock for the CoCo
to turn into. Instead, it converts into an immediate cash payment of 25% of the principal amount if
Rabobanks equity capital ratio falls below 7%. For our theoretical analysis we consider the following
prototype:
The maturity is T, the principal amount is F, and there is a stream of xed coupon payments
1
c
i
at times 0 < t
1
< < t
n
= T.
The trigger event occurs at a random time .
If triggered, the CoCo converts into G shares of equity.
This covers the Lloyds CoCo. The Rabo CoCo is simpler. Instead of G shares of equity it converts
into a payment of G units of currency. All our formulas can easily be adjusted to this case. A CoCo is a
typical hybrid product in that it depends on dierent sources of risk:
Interest rate risk. Before conversion, a CoCo is a xed income product and therefore sensitive to
movements of the risk-free yield curve. This exposure can be hedged with government bonds or
interest rate swaps.
Conversion risk. If the Coco has a market trigger based on one or more liquidly traded securities,
they can be used to hedge conversion risk. Otherwise, we propose to hedge it with CDSs. Conver-
sion risk is related to default risk, and CDSs are issued with long maturities. Many of them are
liquidly traded.
Equity risk. A CoCo that potentially converts into equity is exposed to equity risk. It can be
hedged with equity shares, futures or options. Write-down and write-o CoCos have no exposure
to equity risk.
1
For simplicity we only consider xed coupon payments. Floating coupon rates can be covered with minor modications.
2
A general CoCo model should include all relevant sources of risk. Moreover, for calibration and
hedging purposes it should lend itself to the ecient valuation of related instruments. For a CoCo that is
triggered by the market value of the issuing rms equity, it is enough to model the rms stock price and
risk-free interest rates. Other trigger mechanisms require additional model components. If conversion
is not triggered by liquidly traded instruments, we propose to hedge it with CDSs. To price them, one
must describe the rms default time. Two kind of models have been studied extensively in the credit
risk literature: structural models, which go back to Merton (1974) and describe bankruptcy as an event
in which the value of a rms total assets falls below that of its liabilities, and reduced form models,
originated by Jarrow and Turnbull (1995), in which credit events happen when a point process jumps.
We investigate both approaches to modeling the trigger event and describe default in the same way. More
precisely, in a structural model we assume conversion and default to occur at hitting times of a stochastic
process and in a reduced form model at the rst two jump times of a time-changed Poisson process. In
the structural approach the trigger process could be a market price, an accounting ratio or a quantity
observed by regulators. We assume it to be continuous and observable. Then the prices of the issuing
rms stock and the CoCo are not expected to jump at conversion since even if the rms equity is diluted
at conversion, investors continuously take this into account before it happens. A reduced form model can
describe any trigger mechanism not directly based on liquidly traded securities. It models conversion and
default as jumps of a time-changed Poisson process. Therefore, they come as a surprise, and prices of
the rms stock, the CoCo and CDSs are expected to jump. In both cases it is theoretically possible to
perfectly hedge the CoCo by dynamically investing in enough non-redundant securities. In practice it is
important that they be liquidly traded and oer exposure to the same types of risk as the CoCo. As case
studies we price the CoCos issued by Lloyds Banking Group on Dec 1, 2009 and Rabobank on March
19, 2010 by calibrating a structural and reduced form model to market quotes of equity shares, risk-free
yields and CDS spreads. Both approaches need the recovery rate used in the calibration to CDS spreads
as an input. It can be estimated from historical default data or inferred from time series of CDS spreads
as, for instance, in Pan and Singleton (2008). Alternatively, it can be chosen so that the model prices
the CoCo at market value, yielding a CoCo-implied recovery rate. Both our model specications priced
the Lloyds CoCo at market value with an implied recovery rate of 60% or more, signicantly higher than
the 40% often assumed by practitioners. This suggests that on the pricing date, Oct 14, 2011, either the
market price of the Lloyds CoCo was low compared to interest rate swaps, the rms stock price and
CDSs, or investors were expecting the recovery rate to be considerably higher than the standard 40%.
The Rabo CoCo was priced at market value by both models with an implied recovery rate very close to
40%. So under standard assumptions, they priced the Rabo CoCo practically at their market value.
Most of the existing quantitative CoCo studies take a structural approach. Raviv (2004) as well
as Hilscher and Raviv (2012) use the barrier approach of Black and Cox (1976) to price CoCos. De
Spiegeleer and Schoutens (2012) and its generalization Corcuera et al. (2012) focus on modeling the
issuing rms equity value and approximate accounting triggers by an event where the stock price falls
below some level. Papers that use a structural model for studying CoCo designs include Pennachi (2010),
Albul et al. (2010), McDonald (2010), Glasserman and Nouri (2010), Koziol and Lawrenz (2011), Bolton
and Samama (2012), Buergi (2012), Berg and Kaserer (2012), Brigo et al. (2013), Metzler and Reesor
(2013), Pennachi et al. (2013). For a critical assessment of some of the existing CoCo pricing models we
refer to Wilkens and Bethke (2012).
The contribution of this paper consists in a general CoCo framework that can be specied in dierent
ways. The structure of the paper is as follows. In Section 2 we provide formulas for the pricing and
calibration of CoCos in the case where conversion happens at a general stopping time. In Section 3 we
study structural models and in Section 4 reduced form models. In both cases we assume the underlying
3
uncertainty to be generated by a nite-dimensional Markov process. Then a CoCo can be hedged with
a dynamic trading strategy if there exist enough liquidly traded securities with exposure to the same
sources of risk. In Section 5 we use a structural and reduced form model to value CoCos issued by Lloyds
Banking Group and Rabobank.
2 General formulas for pricing, calibration and hedging
We consider a nancial institution with outstanding CoCos and assume that its equity shares pay div-
idends at a constant rate q 0
2
. We model the market price of an equity share and the instantaneous
risk-free interest rate with stochastic processes (S
t
)
t0
and (r
t
)
t0
. The ltration generated by all observ-
able events is denoted by (F
t
)
t0
, and discounted prices of future cash-ows are assumed to be martingales
under a risk neutral probability measure Q. In particular,

S
t
:= e

t
0
rsds
e
qt
S
t
is a Q-martingale, and the
time-t price of a risk-free zero-coupon bond with maturity s is given by P(t, s) := E
Q
t
_
e

s
t
rvdv
_
, where
E
Q
t
denotes the conditional expectation with respect to F
t
. We denote the conversion time by and the
default time by . We assume both of them to be stopping times with respect to (F
t
) and , that
is, the rm cannot go into bankruptcy before conversion has been triggered. In Section 3, and are
both modeled as hitting times of a stochastic process and in Section 4 as the rst two jump times of a
time-changed Poisson process.
A standard CoCo can be viewed as the sum of a defaultable bond and an option that delivers a xed
number of equity shares if the trigger event occurs. If the CoCo has not converted by time t < T and
can be hedged with liquid securities, its unique arbitrage-free price is
C
t
=

t
i
>t
c
i
E
Q
t
_
e

t
i
t
rsds
1
{>t
i
}
_
+

t
i
>t
c
i
E
Q
t
_
e


t
rsds
t
i1
t
i
t
i1
1
{t
i1
<t
i
}
_
+FE
Q
t
_
e

T
t
rsds
1
{>T}
_
+GE
Q
t
_
e


t
rsds
S

1
{T}
_
.
(2.1)
The rst two terms represent the value of future coupon payments together with accrued interest payed
upon conversion. The third term is the value of the principal and the last term the value of a possible
conversion into equity. If the CoCo converts into a cash payment instead of equity shares, formula (2.1)
is easily adjusted by replacing the last term with
GE
Q
t
_
e


t
rsds
1
{T}
_
. (2.2)
The following result gives the price in a more convenient form (Q
t
, Q
i
t
, Q

t
denote conditional proba-
bilities with respect to F
t
).
Theorem 2.1. If by time t < T the CoCo has not converted yet, its price C
t
can be written as

t
i
>t
c
i
P(t, t
i
)Q
i
t
[ > t
i
] +

t
i
>t
c
i
t
i
t
i1
E
Q
t
_
e


t
rsds
( t
i1
)1
{t
i1
<t
i
}
_
+FP(t, T)Q
n
t
[ > T] +GS
t
E
Q

t
_
e
q(t)
1
{T}
_
,
(2.3)
2
The model could be extended to include stochastic dividends. But this would only have a minor inuence on the price
of a CoCo.
4
where the measures Q
i
and Q

are dened by
dQ
i
dQ
=
e

t
i
0
rsds
E
Q
_
e

t
i
0
rsds
_ and
dQ

dQ
=

S
T
S
0
. (2.4)
If the CoCo converts into a cash payment instead of equity, the last term of formula (2.3) has to be
replaced with
GE
Q
t
_
e


t
rsds
1
{T}
_
. (2.5)
In the special case where is independent of (r
s
)
tsT
with respect to Q
t
, the rst three terms of formula
(2.3) simplify to

t
i
>t
c
i
P(t, t
i
)Q
t
[ > t
i
],

t
i
>t
c
i
t
i
t
i1
E
Q
t
_
P(t, )( t
i1
)1
{t
i1
<t
i
}

, FP(t, T)Q
t
[ > T] (2.6)
and the expression (2.5) to
GE
Q
t
_
P(t, )1
{T}

.
Remark 2.2. It is possible that if a CoCo converts, there is a structural break in the dynamics of the
stock price S
t
. First, the capital structure of the rm changes, and moreover, the management might
implement a new strategy, or the company is restructured. However, for the valuation of CoCos it is
enough to specify the stock price S
t
up to time T and make sure that

S
tT
is a Q-martingale. If
one extends the process

S
t
beyond T in such a way that it stays a Q-martingale until time T, one
can dene Q

by dQ

/dQ =

S
T
/S
0
. Then formula (2.3) still holds since the term under the conditional
expectation E
Q

t
is F
T
-measurable. If the CoCo converts into a cash payment, one does not have to
model the stock price S
t
at all, except in the case where the conversion trigger depends on it, or it is
needed to model CDSs.
A meaningful model should also be able to price liquidly traded instruments that are related to CoCos
such as the issuing rmss stock, xed income products and CDSs. The stock price S
t
is a building block
of our model, and risk-free zero-coupon bonds are given by P(t, s) = E
Q
t
_
e

s
t
rvdv
_
. Moreover, we assume
that at the pricing date t < T, there exist K liquidly traded CDS contracts with maturities T
1
< < T
K
lying on an equally spaced grid t < s
1
< s
2
< . . . such that T
K
T. If the CoCo has not converted until
time t, default has not occurred. Therefore, the time-t value of a protection buyer position in a CDS
with coupon times s
i
and maturity T
k
is PL
t
CL
t
, where
PL
t
= (1 R)E
Q
t
_
e


t
rsds
1
{T
k
}
_
(2.7)
is the value of the protection leg and
CL
t
=

t<s
i
T
k
s E
Q
t
_
e

s
i
t
rsds
1
{>s
i
}
_
+E
Q
t
_
e


t
rsds
( s
i1
)1
{s
i1
<s
i
}
_
(2.8)
the value of the coupon leg. R is the recovery rate. In reality it is random. But for simplicity, practitioners
usually assume it to be constant
3
(often around 40%). It could be estimated from past defaults or with
3
More generally, one can assume the recovery rate to be a random variable independent of other components of the
model. This adds the exibility that its expectation can be dierent under the statistical and pricing measure. Instead of
a fraction of the principal, one could also model the recovery amount as a fraction of the discounted principal or market
value; we refer to Due and Singleton (1999) for more details.
5
the method of Pan and Singleton (2008) from time series of CDS spreads and then use it for CoCo
pricing. Alternatively, it can be chosen so that the model prices CoCos at market value, resulting in
a CoCo-implied recovery rate. s denotes the time between coupon payments in years. It normally is
1/4 or 1/2. is the spread and specied in the contract. Formula (2.8) gives the time-t value of future
coupons payments including accrued interest. Before CDSs were standardized, the spread was usually
set so that no initial cash-ow was necessary. Now this is in general no longer possible. But the price of
a CDS with maturity T
k
is still quoted in terms of the spread that would make its current price equal to
zero:
(t, T
k
) =
(1 R)E
Q
t
_
e


t
rsds
1
{T
k
}
_

t<s
i
T
k
s E
Q
t
_
e

s
i
t
rsds
1
{>s
i
}
_
+E
Q
t
_
e


t
rsds
( s
i1
)1
{s
i1
<s
i
}
_. (2.9)
In the models of Sections 3 and 4 below we assume and to be independent of the short rate. Then it
follows as in the proof of Theorem 2.1 that (t, T
k
) can be written as
(t, T
k
) =
(1 R)E
Q
t
_
P(t, )1
{T}

t<s
i
T
k
sP(t, s
i
)Q
t
[ > s
i
] +E
Q
t
_
P(t, )( s
i1
)1
{s
i1
<s
i
}
. (2.10)
So to price all relevant instruments in the models of Sections 3 and 4, it will be enough to compute the
following quantities:
Q
t
[ > t
i
], E
Q

t
_
e
q
1
{T}

, E
Q
t
_
P(t, )1
{t
i
}

, E
Q
t
_
P(t, )1
{t
i
}

Q
t
[ > s
i
], E
Q
t
_
P(t, )1
{s
i
}

, E
Q
t
_
P(t, )1
{s
i
}

.
(2.11)
Since we are only interested in the price of a CoCo as long as it has not converted, we just have to
calculate the expressions (2.11) in the case t < . Moreover, for pricing and calibration we take the
whole curve P(t, .) as given. For nitely many tenors the prices of zero-coupon bonds can be deduced
from market data of government bonds or interest rate swaps. From there the curve can be completed by
interpolation. So for pricing and calibration, one does not need an explicit model for the short rate (r
t
).
To hedge interest rate risk one can either specify the dynamics of (r
t
) or just immunize against the most
common movements of the risk-free yield curve. The hedging aspect will be discussed in more detail in
the frameworks of the following two sections.
3 Structural models
In this section we assume that the randomness is generated by a d-dimensional diusion process that can
be realized as the unique strong solution of an SDE of the form
dX
t
= a(X
t
)dt +b(X
t
)dW
t
, (3.1)
where (W
t
) is a d-dimensional Brownian motion and a : R
d
R
d
, b : R
d
R
dd
are deterministic
functions. We suppose that the instantaneous risk-free interest rate is of the form
r
t
= r(X
t
) for a continuous function r : R
d
R. (3.2)
The conversion time and default time are assumed to be hitting times:
= inf {t 0 : H
t
h

} , = inf {t 0 : H
t
h

} , (3.3)
6
where h

are constants and H


t
is a process of the form H
t
= h(X
t
) for a continuous function
h : R
d
R. We think of H
t
as a capital ratio since most existing CoCos have an accounting trigger.
Alternatively, it could be the stock price
4
, an index or a quantity that is observed by the regulator. To
keep the model tractable, we assume that (H
t
) is continuous, observable and independent of (r
t
). Then
and are predictable and independent of (r
t
). This means that conversion does not come as a surprise,
and therefore, even though the number of equity shares increases at time , it should not induce a jump
in the stock price since investors continuously take the possibility of conversion into account before the
trigger event happens.
We assume that for t , the stock price S
t
equals X
1
t
, and the rst component of the SDE (3.1)
reads as
dX
1
t
= X
1
t
(r
t
q)dt +X
1
t
(X
t
)
T
dW
t
for a volatility function : R
d
R
d
such that

S
t
= exp
__
t
0
(X
s
)
T
dW
s

1
2
_
t
0
(X
s
)
T
(X
s
)ds
_
is a martingale under Q. Theoretically, one could add jumps to the process (H
t
) or assume it to be
only partially observable. In this case, there would be an element of surprise if the trigger event occurs,
and one would expect the stock price to jump. However, it would make the model much more complex.
In Section 4 below we discuss the other extreme where conversion happens at the rst jump time of a
time-changed Poisson process and therefore is not predictable.
3.1 CoCo and CDS pricing with PDEs
The distributions of hitting times are known in closed form only in special cases. But the quantities
(2.11) can always be obtained by solving simple parabolic PDEs with Dirichlet boundary conditions.
Let D :=
_
x R
d
: h(x) > h

_
and denote for all (t, x) [0, T] D by Q
t,x
the probability Q
conditioned on X
t
= x and > t. For the corresponding conditional expectation we write E
Q
t,x
.
The following four propositions give PDEs for Q
t,x
[ > t
i
], E
Q

t,x
[e
q
1
{T}
], E
Q
t,x
_
P(t, )1
{t
i
}

and
E
Q
t,x
_
P(t, )1
{t
i
}

. The PDEs for Q


t,x
[ > s
i
], E
Q
t,x
_
P(t, )1
{s
i
}

and E
Q
t,x
_
P(t, )1
{s
i
}

are the
same, except that the conversion level h

has to be replaced with the default level h

.
Proposition 3.1. Fix i = 1, . . . , n, and assume there exists a bounded function u : [0, t
i
]

D R
satisfying the PDE
u
t
(t, x) +Au(t, x) = 0, u(t, x) = 0 for x D, u(t
i
, x) = 1
D
(x), (3.4)
where
Au(t, x) :=

j
a
j
(x)
u
x
j
(t, x) +
1
2

j,k

jk
(x)

2
u
x
j
x
k
(t, x), (x) := b(x)b(x)
T
.
Then
u(t, x) = Q
t,x
[ > t
i
] for all (t, x) [0, t
i
] D.
4
The case where conversion is triggered if the stock price breaches a lower barrier is discussed in the appendix.
7
Proposition 3.2. Assume u : [0, T]

D R is a bounded solution of the PDE
u
t
(t, x) +A

u(t, x) = 0, u(t, x) = e
qt
for x D, u(T, x) = e
qT
1
D
(x), (3.5)
where
A

u :=

j
a

j
(x)
u
x
j
(t, x) +
1
2

j,k

jk
(x)

2
u
x
j
x
k
(t, x), a

(x) := a(x) +b(x)(x).


Then
u(t, x) = E
Q

t,x
[e
q
1
{T}
] for all (t, x) [0, T] D.
Proposition 3.3. Fix i = 1, . . . , n, t < t
i
and x D. If u : [t, t
i
]

D R is a bounded solution of the
PDE
u
t
(s, y) +Au(s, y) = 0, u(s, y) = P(t, s) for y D, u(t
i
, y) = P(t, t
i
)1
D
(y), (3.6)
then
u(t, x) = E
Q
t,x
_
P(t, )1
{T}

.
Proposition 3.4. Fix i = 1, . . . , n, t < t
i
and x D. If u : [t, t
i
]

D R is a bounded solution of the
PDE
u
t
(s, y) +Au(s, y) = 0, u(s, y) = P(t, s)s for y D, u(t
i
, y) = P(t, t
i
)t
i
1
D
(y), (3.7)
then
u(t, x) = E
Q
t,x
_
P(t, )1
{T}

.
3.2 Hedging in structural models
We now address the hedging of a CoCo in a structural model. The goal is to replicate the CoCo by
investing in liquidly traded securities. This hedges a short CoCo position. A long position is hedged with
the opposite strategy. Let us assume that there exists a money market account with instantaneous return
r
t
and an additional d non-redundant liquid securities. A unit of currency invested in the money market
grows like
0
t
= exp(
_
t
0
r
s
ds), and since X
t
is a Markov process, prices of the CoCo and all other securities
at time t < are given by (t, X
t
) and
j
(t, X
t
) for deterministic functions ,
j
: [0, T] R
d
R.
3.2.1 Perfect hedge
If the functions ,
j
are C
1,2
on [0, T) R
d
, it follows from Itos lemma that the CoCo can perfectly be
hedged with a dynamic trading strategy
j
t
, j = 0, . . . , d, satisfying

x
i
(t, X
t
) =
d

j=1

j
t

j
x
i
(t, X
t
), i = 1, . . . , d, and (t, X
t
) =
0
t

0
t
+
d

j=1

j
t

j
(t, X
t
) (3.8)
at all times t < . In theory, since the d-dimensional Brownian motion W has the predictable representa-
tion property, any d non-redundant securities can be used as hedging instruments. However, in practice
one would naturally try to use securities with exposure to the same risk sources as the CoCo.
8
3.2.2 Perfect hedge for a CoCo that is not triggered by the stock price
In case conversion is not caused by the stock price, the CoCo can be hedged with stock shares, CDSs
and interest rate swaps. To compute a realistic hedging strategy we make the following assumptions:
a)
1
is the stock S
b)
2
, . . . ,
m+1
are m CDSs, H
t
only depends on X
2
t
, , X
m+1
t
, and the coecients of the SDEs for
X
2
t
, , X
m+1
t
do not depend on X
1
t
c)
m+2
, . . . ,
d
are interest rate swaps, r
t
only depends on X
m+2
t
, . . . , X
d
t
, and the coecients of the
SDEs for X
m+2
t
, , X
d
t
do not depend on X
1
t
, . . . , X
m+1
t
.
Then for t < the system of equations (3.8) can be written as
GE
Q

t
_
e
q(t)
1
{T}
_
=
1
t

x
i
(t, X
t
) =
m+1

j=2

j
t

j
x
i
(t, X
t
) for i = 2, , m+ 1

x
i
(t, X
t
) =
d

j=2

j
t

j
x
i
(t, X
t
) for i = m+ 2, . . . , d
(t, X
t
) =
0
t

0
t
+
d

j=1

j
t

j
(t, X
t
).
For xed t < , this is a system of d+1 linear equations in
0
t
, . . . ,
d
t
, which, if it is regular, has a unique
solution. Under assumptions a)c), which are reasonable if the CoCo is not directly triggered by S, stock
shares are only used to hedge equity risk. As a consequence, the hedging position in the stock
1
t
never
exceeds the number of equity shares G the CoCo converts into if triggered. If conversion is triggered
by the stock price, one invests in equity shares to hedge equity and conversion risk. So investments in
the stock might exceed G; see De Spiegeleer and Schoutens (2012). If the CoCo converts into a cash
payment,
1
t
is zero.
3.2.3 Hedging without specifying the interest rate
Instead of specifying the full model and trying to implement a complete hedge, one can invest in the
stock and dierent CDSs to hedge the equity and conversion risk and then immunize against movements
of the risk-free yield curve. This has the advantage that the short rate (r
t
) does not have to be modeled
explicitly. For simplicity we here only immunize against parallel shifts of the risk-free yield curve. But
one can also take other movements, like twists and changes in curvature, into account. As before, we
consider a CoCo that is not triggered by the issuing rms stock price and assume a)b) from above. But
we do not make any assumptions on the interest rate (r
t
), except that it is a Markov process independent
of (H
t
).
For given t < , one holds
1
t
= GE
Q

t
_
e
q(t)
1
{T}

stock shares and invests in the m CDSs such


that

x
i
(t, X
t
) =
m+1

j=2

j
t

j
x
i
(t, X
t
) for i = 2, , m+ 1.
9
Then one invests in xed income products to immunize against parallel shifts of the yield curve. The
sensitivity of the CoCo with respect to a parallel shift of the yield curve is the negative of the absolute
FisherWeil duration (AFW), which for a standard CoCo, is
Y
t
=

t
i
>t
c
i
(t t
i
)P(t, t
i
)Q
t,s
[ > t
i
] +F(T t)P(t, T)Q
t,x
[ > T]
+

t
i
>t
c
i
t
i
t
i1
E
Q
t,x
_
( t)P(t, )( t
i1
)1
{t
i1
<t
i
}

,
(3.9)
and for a CoCo converting into cash,
Y
t
=

t
i
>t
c
i
(t t
i
)P(t, t
i
)Q
t,x
[ > t
i
] +F(T t)P(t, T)Q
t,x
[ > T]
+

t
i
>t
c
i
t
i
t
i1
E
Q
t,x
_
( t)P(t, )( t
i1
)1
{t
i1
<t
i
}

+GE
Q
t,x
_
P(t, )1
{T}

.
(3.10)
Investments in the stock are not sensitive to movements of the risk-free yield curve, and the AFW of a
protection buyer position in a CDS with maturity T
k
is
Y
k
t
=(1 R)E
Q
t,x
_
( t)P(t, )1
{T}

t<s
i
T
k
s(s
i
t)P(t, s
i
)Q
t,x
[ > s
i
] +E
Q
t,x
_
( t)P(t, )( s
i1
)1
{s
i1
<s
i
}

.
(3.11)
So parallel shifts of the yield curve can be neutralized by investing in a xed income portfolio with AFW
Y
t

m+1
j=2

j
t
Y
j
t
.
The durations (3.9)(3.11) are readily computed if one knows the quantities (2.11) together with
E
Q
t,x
_
P(t, )
2
1
{t
i
}

and E
Q
t,x
_
P(t, )
2
1
{s
i
}

.
The latter two can be calculated by solving the same PDE as in Proposition 3.4 with adjusted boundary
conditions.
4 Reduced form models
In this section we assume that the underlying noise is generated by (X
t
) and (N
t
), where (X
t
) is a
d-dimensional diusion process of the form (3.1) and (N
t
) a one-dimensional standard Poisson process.
Since a Brownian motion and a Poisson process dened on the same probability space are automatically
independent, it follows that (X
t
) is independent of (N
t
). As in Section 3, we assume the instantaneous
risk-free interest rate r
t
to be given by r(X
t
) for a continuous function r : R
d
R. In addition we
introduce a continuous function : R
d
R
+
and set
t
:= (X
t
). The conversion time and default time
are modeled as the rst two jump times of the time-changed Poisson process N
t
, where
t
:=
_
t
0

s
ds.
It is natural to have negative correlation between the increments of (
t
) and (S
t
). When the stock price
decreases, market participants are anticipating a higher likelihood of conversion and default. However,
we assume (
t
) and (r
t
) to be independent. Then and are independent of (r
t
). Moreover, we suppose
that the rst line of equation (3.1) can be written as
dX
1
t
X
1
t
= (r
t
q
t
)dt +(X
t
)
T
dW
t
,
10
and for t , the stock price moves like
dS
t
S
t
= (r
t
q
t
)dt +(X
t
)
T
dW
t
+dN
t
, (4.1)
for a function : R
d
R
d
and a constant 1 such that

S
t
=
_
exp
_
_
t
0
(X
s
)
T
dW
s

1
2
_
t
0
(X
s
)
T
(X
s
)ds
t
_
, t <
(1 +)

, t
is a martingale under Q. This means that before conversion, (S
t
) is continuous, and at time it jumps by
S

. It is dicult to predict whether and by how much the stock price will jump in reality. It will depend
on the specics of the CoCo contract and the situation the company will be in. Furthermore, the state
of the nancial sector and the broader economy might play a role. If, for instance, conversion happens
during a systemic crisis, the stock price might react dierently than in normal times. For simplicity we
assume to be a constant. Then one can consider the conclusions of the model for dierent values of
, or one can estimate by modeling the balance sheet. For instance, if one assumes that at conversion
of the CoCo, the changes in market value of all items on the balance sheet cancel out, one obtains the
following equation for the fraction
t
by which the stock price would jump if conversion were to happen
at time t:
n
E

t
S
t
+n
C
(G(1 +
t
)S
t
C
t
) +J
L
t
= 0. (4.2)
Here n
E
denotes the number of equity shares before conversion, n
C
the number of outstanding CoCos
and J
L
t
the jump in market value of all remaining liabilities if conversion were to happen immediately.
So
t
really is a stochastic process, and since C
t
is a function of future values of
t
, solving equation (4.2)
for
t
would amount to a xed point problem. However, to price and hedge a CoCo on an interval [t, T],
one can approximate the jump fraction as follows:
1. Calculate C
t
assuming the stock does not jump at conversion.
2. Choose R such that equation (4.2) holds at time t.
3. Use to price and hedge the CoCo during the interval [t, T].
4.1 CoCo and CDS pricing with intensities
In the following proposition we provide formulas for the quantities (2.11) in terms of the jump intensity
(
t
).
11
Proposition 4.1. Assume has not occurred until time t < T. Then
Q
t,x
[ > t
i
] = E
Q
t,x
_
e
(t
i
t)
_
E
Q

t,x
[e
q
1
{T}
] =
_
T
t
e
qs
E
Q

t,x
_
(1 +)
s
e
(1+)(st)
_
ds
E
Q
t,x
[P(t, )1
{t
i
}
] =
_
t
i
t
P(t, s)E
Q
t,x
_

s
e
(st)
_
ds
E
Q
t,x
[P(t, )1
{t
i
}
] =
_
t
i
t
P(t, s)sE
Q
t,x
_

s
e
(st)
_
ds
Q
t,x
[ > s
i
] = E
Q
t,x
_
(1 +
s
i

t
)e
(s
i
t)
_
E
Q
t,x
_
P(t, )1
{s
i
}

=
_
s
i
t
P(t, s)E
Q
t,x
_

s
(
s

t
)e
(st)
_
ds
E
Q
t,x
_
P(t, )1
{s
i
}

=
_
s
i
t
P(t, s)sE
Q
t,x
_

s
(
s

t
)e
(st)
_
ds.
The next result is useful for calculating the expectations on the right side of the equations in Propo-
sition 4.1.
Proposition 4.2. Denote

t,x
(s, z) := E
Q
t,x
_
e
z(st)
_
, s t, z 0,
and assume that E
Q
t,x
_
sup
tus

< for all s t. Then

t,x
s
(s, 1) = E
Q
t,x
_

s
e
(st)
_

t,x
z
(s, 1) = E
Q
t,x
_
(
s

t
)e
(st)
_

t,x
sz
(s, 1)

t,x
s
(s, 1) = E
Q
t,x
_

s
(
s

t
)e
(st)
_
.
Remark 4.3. Analogously to Proposition 4.2 one can introduce

t,x
(s, z) := E
Q

t,x
_
e
z(1+)(st)
_
, s t, z 0,
and show that if E
Q

t,x
_
sup
tus

< , then

t,x
s
(s, 1) = E
Q

t,x
_
(1 +)
s
e
(1+)(st)
_
.
4.2 Hedging in reduced form models
As in Section 3 we assume there exists a money market account growing like
0
t
= exp(
_
t
0
r
s
ds). To
completely hedge a CoCo in a reduced form model one needs one more liquid instrument than in a
structural model due to the additional uncertainty coming from the Poisson process (N
t
). (X
t
, N
t
) is still
a Markov process. So the prices of the CoCo and any d + 1 hedging instruments before conversion are
given by (t, X
t
) and
j
(t, X
t
) for deterministic functions ,
j
: [0, T] R
d
R.
12
4.2.1 Perfect hedge
If the functions and
j
are C
1,2
on [0, T) R
d
, one obtains from Itos lemma that a standard CoCo
can be hedged perfectly with a dynamic strategy
j
t
, j = 0, . . . , d + 1, satisfying for all t < ,

x
i
(t, X
t
) =
d+1

j=1

j
t

j
x
i
(t, X
t
), i = 1, . . . , d
G(1 +)X
1
t
(t, X
t
) =
d+1

j=1

j
t

j
(t, X
t
)
(t, X
t
) =
0
t

0
t
+
d+1

j=1

j
t

j
(t, X
t
),
where
j
(t, X
t
) denotes the jump-to-conversion, that is, the price jump of the j-th security if the CoCo
were to convert at time t. Not all security prices jump if the CoCo converts. But in this model CDSs
do so since the default intensity jumps up.
4.2.2 Perfect hedge for a CoCo that is not triggered by the stock price
If the CoCo is not triggered by the issuing rms stock price, one can hedge it by investing in the stock,
CDSs and interest rate swaps. Let us assume the following:
a)
1
is the stock S
b)
2
, . . . ,
m+2
are m+1 CDSs,
t
only depends on X
2
t
, . . . , X
m+1
t
, and the coecients of the SDEs
for X
2
t
, . . . , X
m+1
t
do not depend on X
1
t
c)
m+3
, . . . ,
d+1
are interest rate swaps, r
t
only depends on X
m+2
t
, . . . , X
d
t
, and and the coecients
of the SDEs for X
m+2
t
, . . . , X
d
t
do not depend on X
1
t
, . . . , X
m+1
t
.
Then to construct the hedging portfolio
t
, one has to solve the following system of equations for all
t < :
GE
Q

t
_
e
q(t)
1
{T}
_
=
1
t

x
i
(t, X
t
) =
m+2

j=2

j
t

j
x
i
(t, X
t
) for i = 2, . . . , m+ 1

x
i
(t, X
t
) =
d+1

j=2

j
t

j
x
i
(t, X
t
) for i = m+ 2, . . . , d + 1
G(1 +)X
1
t
(t, X
t
) =
1
t
X
1
t
+
m+2

j=2

j
t

j
(t, X
t
)
(t, X
t
) =
0
t

0
t
+
d+1

j=1

j
t

j
(t, X
t
).
13
4.2.3 Hedging without specifying the interest rate
If the interest rate (r
t
) is not specied one can invest in S
t
and dierent CDSs to hedge against eq-
uity and conversion risk and then immunize against movements of the risk-free yield curve. As in the
structural model, we only neutralize parallel shifts. Let us assume that the CoCo is not triggered by
the stock price, a)b) from above hold and (
t
) is independent of (r
t
). Then for t < , one buys

1
t
= GE
Q

t
_
e
q(t)
1
{T}

stock shares and invests in the m+ 1 CDSs such that

x
i
(t, X
t
) =
m+2

j=2

j
t

j
x
i
(t, X
t
) for i = 2, , m+ 1,
and
G(1 +)X
1
t
(t, X
t
) =
1
t
X
1
t
+
m+2

j=2

j
t

j
(t, X
t
).
After that one immunizes against parallel shifts of the yield curve by purchasing a xed income portfolio
with AFW Y
t

m+1
j=2

j
t
Y
j
t
. It can be shown as in Proposition 4.1 that
E
Q
t,x
_
P(t, )
2
1
{t
i
}

=
_
t
i
t
P(t, s)s
2
E
Q
t,x
_

s
e
(st)
_
ds
and
E
Q
t,x
_
P(t, )
2
1
{s
i
}

=
_
s
i
t
P(t, s)s
2
E
Q
t,x
_

s
(
s

t
)e
(st)
_
ds.
Together with Proposition 4.2 this allows to calculate the AFWs of the CoCo and the CDSs.
5 Examples
In this section we apply a structural and reduced form model to price CoCos issued by Llyods Banking
Group and Rabobank. In both models, we use a small number of stochastic factors. This already seems
to yield realistic results. But the models can easily be extended by adding more factors. The short rate
does not have to be specied since it enters the pricing formulas only through the zero-coupon bond
prices P(t, s), which for nitely many s-values can be deduced from government bonds or interest rate
swaps. From there the curve can be interpolated.
Like Corcuera et al. (2012) we choose Oct 14, 2011 as the pricing date and use the same data on
risk-free yields and CDS spreads for calibration. The specics of the two CoCos we consider are as follows:
The Lloyds Banking Groups Enhanced Capital Notes (ISIN XS0459089255) were issued on Dec
1, 2009 with a maturity of 10 years. They pay semi-annual coupons at an annual rate of 15%. If
Lloyds Banking Groups Core Tier 1 Ratio falls below 5%, each ECN converts into F/K ordinary
equity shares, where F is the principal amount of the note and K equals 59 pence.
In 2011, Lloyds Banking Group reported a Core Tier 1 Ratio of 9.6%, while Basel III regulation
requires it to be at least 4.5%. On the pricing date the ECNs had a time to maturity of 8.19 years
and traded at 109.9% of their principal amount. The market price of Lloyds Banking Groups stock
was 33.25 pence.
14
The Rabobanks Senior Contingent Notes (ISIN XS0496281618) were issued on March 19, 2010
with a maturity of 10 years. They pay yearly coupons at a rate of 6.875%. They are triggered if
Rabobanks Equity Capital Ratio (equity capital/ risk-weighted assets) falls below 7%. If triggered,
they are written down by 75%, and each note converts into an immediate cash payment of 25% of
the principal amount F.
Rabobank reported an Equity Capital Ratio of 14.7% in 2011, and Basel III requires a minimum
of 4.5%. On the pricing date, the time to maturity of the SCNs was 8.44 years, and they traded at
88.84% of their principal amount.
The following table shows risk-free yields and CDS spreads prevailing on Oct 14, 2011. Lloyds Banking
Groups stock and the ECNs are denominated in GBP. The risk-free yields were extracted from GBP
interest rate swap data. The SCNs are denominated in EUR. The risk-free yields correspond to EUR
interest rate swaps.
GBP risk-free yields and Lloyds Banking Group CDS spreads
Tenor in years 1 2 3 4 5 7 10
Risk-free yield in % 1.73 1.38 1.53 1.73 1.94 2.35 2.81
CDS spread in bps 253.2 286.4 299.3 315.8 325.9 330.2 337.5
EUR risk-free yields and Rabobank CDS spreads
Tenor in years 1 2 3 4 5 7 10
Risk-free yield in % 2.12 1.62 1.75 1.93 2.13 2.47 2.77
CDS spread in bps 50.7 73.7 97.6 109.2 116.3 122.4 127.1
5.1 Structural model with an exponential OU accounting ratio
The easiest model for the accounting ratio would be a (exponential) Brownian motion. But we obtained
a better t to market quotes of CDS spreads with an exponential OrnsteinUhlenbeck process. So we
assume that the stock price follows a geometric Brownian motion
dS
t
= (r
t
q)S
t
dt +S
t
(
_
1
2
dW
1
t
+dW
2
t
)
and the logarithm of the accounting ratio an OrnsteinUhlenbeck process
dH
t
= (mH
t
)dt +dW
2
t
.
Then the measure Q

is given by
dQ

dQ
=

S
T

S
0
= exp
_

_
_
1
2
W
1
T
+W
2
T
_

1
2

2
T
_
,
and it follows from Girsanovs theorem that the dynamics of (H
t
)
t0
can be written as:
dH
t
= (m

H
t
)dt +dW

t
,
where m

= m+/ and W

t
= W
2
t
t is a Brownian Motion under Q

. The problem of pricing and


calibrating CoCos thus reduces to solving linear PDEs with Dirichlet boundary conditions as described in
15
Section 3.1. We solved the PDEs numerically with the CrankNicholson method.
5
In the case of Lloyds
Banking Group, H
t
is meant to model the logarithm of the Core Tier 1 Capital Ratio and in Rabobanks
case the logarithm of the equity capital ratio. exp(h

) is the contractual trigger level (5% for Lloyds


and 7% for Rabobank) and exp(h

) the minimum capital ratio level required by Basel III (4.5% in both
cases).
For a given value of the recovery rate R we calibrated the model by choosing the parameters , m,
and the starting point h of the process (H
t
) so that the CDS spreads produced by the model were close
to the market quotes. However, the error function constructed only with CDS spreads is almost at in
some regions, causing problems for gradient based minimization algorithms. Therefore, we also inferred
the Q-survival probabilities from the CDS spread data using the bootstrapping method of OKane and
Turnbull (2003) and added them to the objective function. More precisely, we chose the parameters
which minimized the function

i=2,3,4,5,7,10
_

model
i

market
i

market
i
_
2
+
_
q
model
i
q
OKT
i
q
OKT
i
_
2
, (5.1)
for the CDS spreads
model
i
,
market
i
implied by the model and market data and the Q-survival probabilities
q
model
i
, q
OKT
i
produced by our model and the one of OKane and Turnbull (2003). It is well-known that
structural models do not t short term CDS spreads well; see for instance, Lando (2004). Therefore, we
dropped the one year CDS spread from the calibration. The following table lists the optimal parameters
corresponding to the CoCo-implied recovery rates, that is, the recovery rates R which made the model
prices of the CoCos equal to their market prices (76.6% for Lloyds and 42% for Rabobank). RMSE
denotes the root mean squared error of the calibration.
Parameters Lloyds Banking Group Rabobank
1.0488 0.2034
exp(m) 9.07% 15.10%
0.5853 0.3960
exp(h) 10.92% 13.14%
R 76.60% 42.00%
RMSE 6.85% 4.74%
The top two panels of Figure 1 compare the Q-survival probabilities of Lloyds Banking Group and
Rabobank implied by our model to the ones constructed with the OKane and Turnbull (2003) approach.
It can be seen that they are almost indistinguishable. The panels in the middle of Figure 1 plot the CDS
spreads generated by our model against the market quotes. The t is not perfect. Especially for Lloyds
Banking Group, the 7- and 10-year CDS spreads predicted by the model are too low. This is in line with,
for instance, Eom et al. (2004) or Huang and Zhou (2012), which argue that standard structural models
do not t CDS spread term structures well. In the case of Rabobank the t is better, which is reected
in a smaller RSME. The two bottom panels of Figure 1 show CoCo prices produced by the model for
dierent values of the recovery rate R chosen in the CDS calibration. The jaggedness of the curves is
caused by numerical instabilities of the calibration.
In the case of Lloyds Banking Group, the CoCo price also depends on , which cannot be inferred
from CDS data. We set it equal to 30% to model a strong positive correlation between the increments of
5
G oing-Jaeschke and Yor (2002) and Alili et al. (2005) derived formulas for hitting time distributions of Ornstein
Uhlenbeck processes. But the expressions given in these papers are so complicated that it was easier for us to solve the
PDEs numerically.
16
0 2 3 4 5 7 10
0.2
0.4
0.6
0.8
1
Lloyds: survival probabilities (recovery rate = 76.60%)
Tenor in years


Market
OU model
2 3 4 5 7 10
200
250
300
350
400
Tenor in years
S
p
r
e
a
d

i
n

b
p
s
Lloyds: CDS spreads


Market
OU model
20 40 60 80
80
100
120
140
160
Lloyds: CoCo price as function of CDS recovery rate
Recovery rate in %
P
r
i
c
e

i
n

%

o
f

t
h
e

p
r
i
n
c
i
p
a
l


0 2 3 4 5 7 10
0.2
0.4
0.6
0.8
1
RaboBank: survival probabilities (recovery rate = 42.00%)
Tenor in years


Market
OU model
2 3 4 5 7 10
50
75
100
125
150
Tenor in years
S
p
r
e
a
d

i
n

b
p
s
RaboBank: CDS spreads


Market
OU model
20 40 60 80
50
60
70
80
90
100
110
RaboBank: CoCo price as function of CDS recovery rate
Recovery rate in %
P
r
i
c
e

i
n

%

o
f

t
h
e

p
r
i
n
c
i
p
a
l


Market
OU model
Market
OU model
Figure 1: Q-survival probabilities, CDS spreads and CoCo prices with exponential OU accounting ratio
the stock price and the accounting ratio. However, it can be seen from the value decomposition in Figure
2 below that a possible conversion into equity accounts for only about 20% of the value of the ECNs.
So the choice of has only a minor inuence on the model price of the ECNs. The calibration yielded
a long term mean for the accounting ratio of 9.07% and an implied accounting ratio at the pricing date
of 10.92%, slightly higher than the reported 9.6%. The CoCo-implied recovery rate R is 76.60%, much
higher than the usually assumed 40%. This suggests that on Oct 14, 2011, either the ECNs traded low
relative to the stock of Lloyds, interest rate swaps and CDSs, or market participants were expecting
a higher recovery rate than usual. In any case, it turned out that the price of the ECNs increased to
around 130% of the principal amount during the rst half of 2012.
17
For Rabobank, the estimated long term mean of the accounting ratio came out as 15.10%, and the
implied capital ratio at the pricing date as 13.14%, slightly below the reported 14.7%. The CoCo-implied
recovery rate for Rabobank was 42.00%. So under standard assumptions, the model would have priced
the SCNs very close to their market value on Oct 14, 2011.
Figure 2 shows the decompositions of the values of the ECNs and the SCNs into the parts stemming
from the coupon payments, the redemption of the principal and a possible conversion. The recovery rate
chosen in the calibration ranges from 10% to 90%. It can be seen that for both CoCos future coupon
payments and a possible redemption of the principal account for most of the total value. For increasing
values of the recovery rate, the model-implied Q-survival probabilities decrease and the conversion values
become larger.
5.2 Reduced form model with a CIR jump intensity
We now consider a reduced form model with a mean-reverting jump intensity. To ensure that it does not
become negative, we model it with a CoxIngersollRoss process. It is then possible to deduce closed
form expressions for the functions
t,x
and

t,x
introduced in Proposition 4.2 and Remark 4.3.
More precisely, we assume that the stock price follows the dynamics
dS
t
S
t
= (r
t
q
t
) dt +
1
dW
1
t
+
2
_

t
dW
2
t
+dN
t
and the jump intensity is a CIR process:
d
t
= (m
t
)dt +
_

t
dW
2
t
.
Then Q

is given by
dQ

dQ
=
_
exp
_

1
W
1
T
+
2
_
T
0

t
dW
2
t

1
2
_

2
1
T +
2
2
_
T
0

t
dt
_

T
_
if > T
(1 +) exp
_

1
W
1

+
2
_

t
dW
2
t

1
2
_

2
1
+
2
2
_

0

t
dt
_

_
if T.
It follows from Girsanovs theorem that the dynamics of (
t
) can be written as
d
t
= m+ (
2
)
t
dt +
_

t
dW

t
,
where W

t
= W
2
t

2
_
t
0

s
ds is a Brownian Motion under Q

. To calculate the expressions of Proposi-


tion 4.1 with the methods of Proposition 4.2 and Remark 4.3 we have to compute the Laplace transforms

t,
(s, z) := E
Q
t,
_
e
z(st)
_
and

t,
(s, z) := E
Q

t,
_
e
z(1+)(st)
_
.
Due to the ane structure of the CIR process one has

t,
(s, z) = e
A(st,z)+B(st,z)
for
A(u, z) =
2z(1 e
(z)u
)
2(z) ((z) )(1 e
(z)u
)
and
B(u, z) =
m

2
_
2 ln
_
1
(z)
2(z)
(1 e
(z)u
)
_
+ ((z) )u
_
,
18
Lloyds: CoCo value decomposition
Recovery rate in %
P
r
i
c
e

i
n

%

o
f

t
h
e

p
r
i
n
c
i
p
a
l


10 20 30 40 50 60 70 80 90
0
20
40
60
80
100
120
140
160
Coupons
Principal
Equity
Rabobank: CoCo value decomposition
Recovery rate in %
P
r
i
c
e

i
n

%

o
f

t
h
e

p
r
i
n
c
i
p
a
l


10 20 30 40 50 60 70 80 90
0
20
40
60
80
100
120
Coupons
Principal
Cash Payment
Figure 2: CoCo value decompositions in the structural model
where (z) =
_

2
+ 2
2
z. It follows that

t,
s
(s, z) =
t,
(s, z)
_
A
u
(s t, z) +
B
u
(s t, z)
_

t,
z
(s, z) =
t,
(s, z)
_
A
z
(s t, z) +
B
z
(s t, z)
_

t,
zs
(s, z) =
t,
(s, z)
_

2
A
zu
(s t, z) +

2
B
zu
(s t, z)
_
+
_
A
z
(s t, z) +
B
z
(s t, z)
_

t,
s
(s, z).
19
Analogous expressions can be found for

t,
(s, z) and

t,
(s, z)/s. For a given zero-coupon curve
P(t, .), one can evaluate the integrals of Proposition 4.2 numerically to obtain approximations to all the
quantities of (2.11).
For a given recovery rate R, we chose the parameters , m, and the initial value of the jump
intensity (
t
) so as to produce CDS spreads consistent with market quotes. As in the structural model,
we added the Q-survival probabilities extracted from CDS spreads with the method of OKane and
Turnbull (2003) to the objective function and minimized the squared error function (5.1). The following
table gives he resulting parameters corresponding to the CoCo-implied recovery rates (60.6% for Lloyds
if = 0 and 39% for Rabobank). It can be seen that the root mean squared errors are considerably
smaller than for the structural model of Subsection 5.1.
Parameters Lloyds Banking Group Rabobank
0.9519 0.2530
m 0.16 0.04
0.0014 0.0001
0.53 0.14
R 60.60% 39.00%
RMSE 1.98% 2.81%
The two panels at the top of Figure 3 show the Q-survival probabilities produced by our reduced
form model and the ones extracted with the method of OKane and Turnbull (2003). As in the structural
approach, they are practically equal. The panels in the middle of Figure 3 show CDS spreads generated
by the model compared to the market quotes. The t is better than in the structural model of Subsection
5.1 above. The last two panels of Figure 3 show CoCo model prices as a function of the recovery rate
chosen in the CDS calibration.
The conversion value of the ECNs also depends on the product
2
and the jump fraction , which
cannot be deduced from CDS spreads. To obtain a negative correlation between the increments of the
stock price and the conversion intensity, we chose
2
equal to -30%. However, since in this example the
empirical value of is very small, the choice of
2
has practically no inuence on the model price of the
ECNs. For gamma we picked values of -20%, 0% and 20%. The resulting dierences in ECN prices are
minor. In all three cases the CoCo-implied recovery rate is around 60%, above the standard 40%. So,
as in Subsection 5.1, the model suggests that on Oct 14, 2011 the market value of the ECNs was low
compared to related products, or investors expected a higher recovery rate than usual. The market price
of the SCNs was consistent with market quotes of interest rate swaps and CDSs for a recovery rate very
close to 40%.
Figure 4 shows the value decompositions of the ECNs and SCNs into the components corresponding
to coupon payments, principal redemption and conversion value. The value of the recovery rate R ranges
from 10% to 90%, and the jump fraction of the stock price of Lloyds Banking Group was set equal
to 0. Like in the structural model, the CoCo prices are decreasing in the recovery rate, and the main
contribution to their values comes from coupon payments and a possible redemption of the principal.
6 Conclusion
This paper develops a framework for the pricing and hedging of CoCos. It introduces a general model
that can price CoCos together with related products such as xed income instruments, equity shares
and CDSs. We concentrated on structural and reduced form specications based on a nite-dimensional
20
0 1 2 3 4 5 7 10
0.4
0.5
0.6
0.7
0.8
0.9
1
Lloyds: survival probabilities (recovery rate = 60.60%)
Tenor in years


Market
CIR model
1 2 3 4 5 7 10
200
250
300
350
400
Tenor in years
S
p
r
e
a
d

i
n

b
p
s
Lloyds: CDS spreads


20 40 60 80
80
100
120
140
Lloyds: CoCo price as function of CDS recovery rate
Recovery rate in %
P
r
i
c
e

i
n

%

o
f

t
h
e

p
r
i
n
c
i
p
a
l


Market
= 0%
= +20%
= 20%
0 1 2 3 4 5 7 10
0.4
0.5
0.6
0.7
0.8
0.9
1
RaboBank: survival probabilities (recovery rate = 39.00%)
Tenor in years


Market
CIR model
1 2 3 4 5 7 10
20
40
60
80
100
120
140
160
Tenor in years
S
p
r
e
a
d

i
n

b
p
s
RaboBank: CDS spreads


Market
CIR model
20 40 60 80
50
60
70
80
90
100
Rabobank: CoCo price as function of CDS recovery rate
Recovery rate in %
P
r
i
c
e

i
n

%

o
f

t
h
e

p
r
i
n
c
i
p
a
l


Market
CIR model
Market
CIR model
Figure 3: Q-survival probabilities, CDS spreads and CoCo prices with CIR jump intensity
Markov process. The two approaches are qualitatively dierent. In a structural model the conversion time
is predictable, and consequently, the prices of CoCos, the issuing rms stock and CDSs are continuous
at conversion. In a reduced form model, conversion comes as a surprise, and prices jump. But both
approaches can be taken to calculate CoCo prices and dynamic hedging strategies. As case studies, we
calibrated a structural and a reduced form model to market quotes of equity, interest rate swaps and
CDSs to price CoCos issued by Lloyds Banking Group on Dec 1, 2009 and Rabobank on March 19,
2010. On Oct 14, 2011 both models would have priced the Lloyds CoCo at market value with an implied
recovery rate of more than 60%. This suggests that on the pricing date, the Lloyds CoCos either traded
at price that was low relative to market quotes of related instruments, or investors were expecting a
21
Lloyds: CoCo value decomposition
Recovery rate in %
P
r
i
c
e

i
n

%

o
f

t
h
e

p
r
i
n
c
i
p
a
l


10 20 30 40 50 60 70 80 90
0
50
100
150
Coupons
Principal
Equity
Rabobank: CoCo value decomposition
Recovery rate in %
P
r
i
c
e

i
n

%

o
f

t
h
e

p
r
i
n
c
i
p
a
l


10 20 30 40 50 60 70 80 90
0
10
20
30
40
50
60
70
80
90
100
Coupons
Principal
Cash Payment
Figure 4: CoCo value decompositions in the reduced form model
considerably higher recovery rate than the standard 40% in case of a default of Lloyds Banking Group.
Both models priced the Rabobank CoCos at market value with an implied recovery rate very close to
40%. Consistently with the credit risk literature, we found that it was easier to reproduce the term
structure of CDS spreads with a reduced form model, and the calibration of a structural model posed
some numerical challenges.
22
A Proofs
Proof of Theorem 2.1
It is clear that the rst and third term of (2.1) can be written as

t
i
>t
c
i
E
Q
t
_
e

t
i
t
rsds
1
{>t
i
}
_
=

t
i
>t
c
i
P(t, t
i
)Q
i
t
[ > t
i
] (A.1)
and
FE
Q
t
_
e

T
t
rsds
1
{>T}
_
= FP(t, T)Q
n
t
[ > T]. (A.2)
To transform the last term, one uses that (

S
t
) is a Q-martingale. Therefore conditioned on > t, one
has
GE
Q
t
_
e


t
rsds
S

1
{T}
_
= GS
t
E
Q
t
_

S

S
t
e
q(t)
1
{T}
_
= GS
t
E
Q

t
_
e
q(t)
1
{T}
_
.
If is independent of (r
s
)
tsT
with respect to Q
t
, the measures Q
i
t
in (A.1)(A.2) can be replaced with
Q
t
, and by rst conditioning on , one obtains

t
i
>t
c
i
t
i
t
i1
E
Q
t
_
e


t
rsds
( t
i1
)1
{t
i1
<t
i
}
_
=

t
i
>t
c
i
t
i
t
i1
E
Q
t
_
P(t, )( t
i1
)1
{t
i1
<t
i
}

,
GE
Q
t
_
e


t
rsds
1
{T}
_
= GE
Q
t
_
P(t, )1
{T}

.
Proof of Propositions 3.13.4
Propositions 3.13.4 are FeynmanKac type results. If u is a bounded solution of the PDE (3.4), then
the process M
t
= u(t , X
t
) is a bounded martingale. So on the set {X
t
= x, > t}, one has u(t, x) =
M
t
= E
Q
t,x
[M
t
i
] = Q
t,x
[ > t
i
], which shows Proposition 3.1.
By Girsanovs theorem, W

t
= W
t

_
t
0
(X
s
)ds is a Brownian motion under Q

, and one can


write dX
t
= a

(X
t
)dt + b(X
t
)dW

t
, t . So if u is a bounded solution of the PDE (3.5), the process
M
t
= u(t , X
t
) is a bounded Q

-martingale. On the set {X


t
= x, > t}, this gives u(t, x) = M
t
=
E
Q

t,x
[M
T
] = E
Q

t,x
[e
q
1
{T}
], which proves Proposition 3.2.
If u is bounded solution of the PDE (3.6), then M
s
= u(s , X
s
) is a bounded martingale. So on
the set {X
t
= x, > t} one has
u(t, x) = M
t
= E
Q
t,x
[M
T
] = E
Q
t,x
_
P(t, )1
{T}

.
This shows Proposition 3.3. The proof of Proposition 3.4 is exactly the same.
Proof of Proposition 4.1
Under Q, conditioned on t < and (
s
), the density of is given by
s
e
(st)
and the one of
by
s
(
s

t
)e
(st)
. So all equalities except the second one follow by rst conditioning on (
s
).
Moreover, it follows from Girsanovs theorem, that under Q

, conditioned on t < and (


s
), the density
of is given by (1 +)
s
e
(1+)(st)
. This yields the second equality.
Proof of Proposition 4.2
One has

t,x
(s, 1) = E
Q
t,x
_
e
(st)
_
= 1
_
s
t
E
Q
t,x
_

u
e
(ut)
_
du,
23
and since E
Q
t,x
_
sup
tus

< , one deduces from Lebesgues dominated convergence theorem that


E
Q
t,x
_

u
e
(ut)

is continuous in u. So
t,x
(s, 1) is continuously dierentiable in s with derivative
E
Q
t,x
_

s
e
(st)

. Moreover, for z > 0, one has

t,x
(s, z)
t,x
(s, 1) =
_
z
1
E
Q
t,x
_
(
s

t
)e
u(st)
_
du,
and (
s

t
)e
u(st)
is uniformly bounded in u. It follows that E
Q
t,x
_
(
s

t
)e
u(st)

is continuous
in u. Therefore,
t,x
(s, z) is continuously dierentiable in z with derivative E
Q
t,x
_
(
s

t
)e
z(st)

.
Analogously, it follows that E
Q
t,x
_
(
s

t
)e
z(st)

, is continuously dierentiable in s with derivative


E
Q
t,x
_
z
s
(
s

t
)e
z(st)

s
e
z(st)

. This completes the proof.


B CoCos with stock price triggers
Market triggers are transparent but have the drawback that they are prone to manipulation. Here we
shortly discuss how they t into the general framework developed in this paper. Let us consider a CoCo
which converts into equity if the stock price S
t
reaches a lower level S

< S
0
. That is, the conversion
time is of the form
= inf {t 0 : S
t
= S

} .
In the benchmark case where the interest rate is equal to a constant r and the stock price evolves like
S
t
= S
0
exp
__
r q
1
2

2
_
t +W
t
_
(B.1)
for a constant volatility and a Q-Brownian motion W, expressions for the quantities (2.11) can be
derived from well-known results on hitting times of Brownian motion. Conditioned on > t, one has
= inf {s t : W
s
=
t
+s}
for

t
=
log S
t
log S

and =
q +
2
/2 r

.
So conditioned on > t, the distribution of under Q
t
is given by Q
t
[ s] =
_
s
t
f
t
(u)du for
f
t
(u) =

t

2u
3
exp
_

1
2u
(
t
u)
2
_
;
see for instance, Steele (2001). This allows to compute the quantities
Q
t
[ > t
i
], E
Q
t
_
P(t, )1
{t
i
}

and E
Q
t
_
P(t, )1
{t
i
}

.
Under the distorted measure Q

=

S
T
/S
0
= exp(W
T

2
T/2), W

t
= W
t
t is a Brownian motion.
Therefore, conditioned on > t, one has Q

t
[ s] =
_
s
t
f

t
(u)du for
f

t
(u) =

t

2u
3
exp
_

1
2u
(
t

u)
2
_
, where

= .
This can be used to evaluate the expectation E
Q

t
_
e
q
1
{T}

.
24
If r
t
and S
t
follow more general diusion dynamics, CoCos with stock price triggers can be priced by
solving PDEs like in Section 3. Calibration and hedging can also be done according to Section 3. Only
now equity shares and options are more closely related to the trigger event than CDSs. However, equity
options often only exist with short maturities and strikes around the money, while CDS contracts are
traded with long maturities; compare to the discussion in Corcuera et al. (2012).
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