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Dilip Madan - On Pricing Contingent Capital Notes.pdf

Dilip Madan - On Pricing Contingent Capital Notes.pdf

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Published by Chun Ming Jeffy Tam
Dilip Madan - On Pricing Contingent Capital Notes.pdf
Dilip Madan - On Pricing Contingent Capital Notes.pdf

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Electronic copy available at: http://ssrn.com/abstract=1971811
On Pricing Contingent Capital Notes
Dilip B. MadanRobert H. Smith School of BusinessUniversity of MarylandCollege Park, MD. 20742Email: dbm@rhsmith.umd.eduDecember 13, 2011
Abstract
A bank’s stock price is modeled as a call option on the spread of ran-dom assets over random liabilities. The logarithm of assets and liabilitiesare jointly modeled as driven by four variance gamma processes and thismodel is estimated by calibrating to quoted equity options seen as com-pound spread options. On de…ning riskweighted assets as asset value lessthe bid price plus the ask price of liabilities less the liability value weendogenize capital adequacy ratios following the methods of conic …nancefor 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 theSquam Lake Report (2010) and the authors of this report encouraged regulatorsto require …nancial institutions to invest in “regulatory hybrid securities.” Theseare long-term debt obligations converting automatically to equity in times of …nancial stress for the issuing entity. Such securities are seen as providingavenues for automatic recapitalization in times of need (Du¢e (2010)). A varietyof 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 CapitalNotes. They include a contingent capital feature with the notes converting toordinary shares if Lloyds’ published consolidated core Tier 1 ratio falls below5%. 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 theanalysis 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. Switzerland’s biggest banks are to hold total capital equal toat least 19 percent of their assets. By 2019, the lenders need to have a commonequity ratio of at least 10 percent and the rest in contingent capital. In responseto these requirements Credit Suisse announced in February 2011 the issuanceof CHF 6 billion trigger tier 1 CoCos called bu¤er capital notes. Regulatorsthroughout Europe are expected to provide further clarity on the use of CoCobonds later this year. It is anticipated that the market for such securities couldgrow to a trillion dollars in the coming years.This activity has led to a demand for CoCo pricing models. There is apotential loss on conversion that is linked to the value of the underlying stockon the conversion date. However, the trigger for conversion is a balance sheetentity like a tier one capital ratio. The components of this ratio are the valueof equity, the level of risk weighted assets and the add ons to be applied torisky liabilities. Risk weighted assets are a measure of potential losses in assetvalues while liability add ons assess the risk of having to unwind risky liabilitiesunfavorably. We note in this regard the model with just risky assets that followa geometric Brownian motion process with a captial ratio trigger of equity toasset values studied in Glasserman and Nouri (2010), that also accomodatespartial conversion.In this paper we generalize the Merton (1974, 1977) approach and treatequity as an option on the spread of risky assets over risky liabilities with astrike determined at the level of debt less cash on hand and a maturity set inthe distant future. Equity options are then compound spread options and weemploy the surface of traded equity options to infer the joint law of risky assetsand 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. Riskweighted assets are taken at the level of assets less a conservative bid price whileadd 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 thushave access to the joint stochastic process for the stock price and the capital ratiothat we employ to price the CoCo note. The pricing procedures are illustratedon data for Credit Suisse.The CoCo notes are USD dollar denominated while the underlying equityoption surfaces are in CHF. We therefore …rst quanto the underlying optionsurfaces into USD. The notes are however not quantoed and take the currencyrisk at conversion. We therefore ADR (American Depository Receipt) the quan-toed surface to build the surface for options on the dollar cost of foreign stockswith dollar strikes. We then calibrate a synthetic dollar denominated asset andliability process from the surface of CHF equity options ADRed into USD.The speci…c model for the stochastic evolution of risky assets and liabilitiesis a linear mixture of independent Lévy processes. We allow for the existenceof idiosyncratic shocks to assets and liabilities along with compensating andcompounding shocks that reduce assets and raise liabilities simultaneously. Wetherefore employ four independent Lévy processes, two idiosyncratic, one com-2
 
pensating and one compounding. The speci…c Lévy processes used are thevariance gamma model with three parameters for each of the four processes.This yields a twelve parameter model for the joint law of assets and liabilitiesthat lies in the
 LG
 class as de…ned in Kaishev (2010).Once the asset and liability model has been calibrated to the USD ADRedsurface of CHF equity options, we price the CoCo by simulating the law of assetsand 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 capitalratio and if a conversion is triggered we evaluate the loss on conversion. Thestress level for bid and ask prices is determined to match the initial or startingreported capital ratio.The steps in the procedure are1. 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 forthe 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 anapplication 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 tothe these triggers being at
 6%
 and
 19
 respectively.
2 The Foreign Equity Option Surface
The …rst step is to parsimoniously represent the risk neutral distributions forthe stock price at all maturities with a few parameters. There are many optionpricing models one may use for this purpose and they include Lévy processes(Schoutens (2003), Cont and Tankov (2004)), stochastic volatility models (He-ston (1993), Carr, Geman, Madan and Yor (2003)) with and without jumpsand Sato processes (Carr, Geman, Madan and Yor (2007)). Lévy processes areparticularly suited to options at a single maturity but as theoretically excesskurtosis and skewness decrease like the reciprocal of maturity and its squareroot respectively, while in data they are relatively constant, these models donot provide a good synthesis when multiple maturities are involved (Konikov3

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