Accounting Noise and the Pricing of Cocos

Abstract

Contingent Convertible bonds (CoCos) are debt instruments that convert into equity or are written down in times of distress. Existing pricing models assume conversion triggers based on market prices and on the assumption that markets can always observe all relevant firm information. But all Cocos issued so far have triggers based on accounting ratios and/or regulatory intervention. We incorporate that markets receive information through noisy accounting reports issued at discrete time instants, which allows us to distinguish between market and accounting values, and between automatic triggers and regulator-mandated conversions. Our second contribution is to incorporate that coupon payments are contingent too: their payment is conditional on the Maximum Distributable Amount not being exceeded. We examine the impact of CoCo design parameters, asset volatility and accounting noise on the price of a CoCo; and investigate the interaction between CoCo design features, the capital structure of the issuing bank and their implications for risk taking and investment incentives. Finally, we use our model to explain the crash in CoCo prices after Deutsche Bank’s profit warning in February 2016.