Design and Pricing of Chinese Contingent Convertible Bonds

Abstract

AbstractThe financial crisis since 2007 has highlighted the fragility of the banking system. To address this deficiency, the Basel committee has agreed upon Basel III which consists of reinforcing banks’ capital through new regulatory requirements. Raising additional funds by issuing common equity would lead to a significant cost for banks. Facing the problem, regulators came up with the concept of contingent capital. Contingent convertible (Coco) bonds have been the topic as both a solution to the “too big to fail” problem and a measure by which financial institutions can save themselves. In this paper we first give the introduction of Coco bonds, then present the design of Chinese Coco bonds and pricing Coco bonds through an equity derivative approach as well as sensitivity analysis based on B-S-M hypothesis. Considering that the stock return follows fat-tail distribution, this paper uses Heston stochastic volatility model to price Coco bonds. Finally we give some proposals for developing Coco bonds market in China.