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Contingent Convertible (CoCo) Notes: Structure and Pricing

Description:
A CoCo stands for a bond that will be converted into equity as soon as the bank gets into a life threatening situation. As soon as the solvency of the bank drops below acceptable standards, the bonds are converted into equity.

Contingent convertible notes (CoCo) made a very modest entry into the financial landscape in November 2009, when LLoyds TSB offered the holders of some of its hybrid debt the possibility to swap these holdings into a new bond with CoCo-features.

A CoCo stands for a bond that will be converted into equity as soon as the bank gets into a life threatening situation. As soon as the solvency of the bank drops below acceptable standards, the bonds are converted into equity. This creates a dilution for the existing shareholders, but the solvency of the bank is improved under circumstances in which it would be typically difficult, if not impossible, to go to the capital markets directly. Some regulators continued on the route of Lloyds TSB. They now advocate the use of these bonds as soon as a bank represents too much systemic risk for the banking system.

Some banks are already engineering new CoCo-note types or consider paying out CoCo-bonuses. For regulators, issuing banks, rating agencies, investors and trading desks around the globe. This makes this book a must read for everybody who wants to understand this asset class.
 
Contents:
Preface

Authors’ notes and acknowledgements

About the authors

List of symbols

Part 1 CoCo note structure

1 Introduction
Definition
Possible trigger
Lloyds and Rabo: some pioneering work
Risk profile
Downside risk
Limited upside potential
Maturity unknown
Are CoCos too exotic?
Auto-callable
Payoff
Example
Risk profile
Are CoCos convertible bonds?

2 Capital structure of a bank: a primer
Components
Overview
Assets
Liabilities
Tier 1 and Tier 2
How hybrid are CoCos?
CoCo note case study
Driving without CoCos
Replacing debt with CoCos
Does size matter?
A lesson from the past
Quality of the capital structure
Basel Committee
Basel I
Basel II
Basel III
Going and gone concern

3 CoCo note history
Rules, rules and more rules
Fortress Europe and the US
Central clearing counterparties
Living wills
Need for more regulatory capital
Previous century’s solutions
Contingent capital in the insurance industry

4 Anatomy of a CoCo
Constructing a bank basket
Funded and unfunded contingent capital
Funded
Unfunded
Contingent event
Conversion in shares
Debt write-down
Conversion amount
Trigger event
Market-based trigger
Accounting trigger
Multi-variate trigger
Regulatory trigger
Conversion price
Regulatory constraints
CoCo note variations
Write-down/write-up
CoCo bonus
CoCoCo
Sovereign contingent capital
Bail-in bonds
The Anglo Irish case
Fast track debt restructuring
Lehman as a case study
Basel Committee on bail-in capital
Rabobank: Basel III innovator
Tier 1 ratios of the bank basket

5 Pro and contra
Advantages
Explicit guarantees
Less systemic risk
Disadvantages
Dilution of existing shareholders
A trigger could create more triggers
Bond investors
No cash injection
Topics for debate
More stability
Trigger
Regulatory classification

Part 2 Cracking CoCos: pricing and risk

6 Pricing a CoCo: introduction

7 Pricing a CoCo: credit approaches
Introduction
Looking at the balance sheet
Reduced form model
Credit spreads
Default intensity
Credit triangle
Extension to CoCos
Application on the Lloyds’ ECNs – I
Calculating the CoCo spread
CoCo rule of thumb
Example
Application on the Lloyds’ ECNs
Application on the Credit Suisse BCN

8 Pricing a CoCo: equity derivative approaches
Barrier options: introduction
Introduction
Definitions
Barrier arithmetic
Barrier options: pricing
Black and Scholes formula
Down-and-in call and put
Pricing binary barrier options
Pricing CoCos: derivatives framework
Zero coupon CoCo
Adding coupons to the CoCo model
Modelling a market trigger
Modelling accounting triggers

9 Dynamics
Introduction
Equity sensitivity (D)

10 CoCos in the market
Introduction
Rating Agencies
Bond Indices
Issuers
Investors
Retail investors
Insurance companies
Hedge funds
Investment funds
Regulators
Bank for International Settlements (BIS)
Financial Stability Board (FSB)
United States
United Kingdom
Switzerland

Bibliography
 
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