Title: 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.