Understanding Additional Tier 1 CoCo Bond Prices using First-Passage Time Models

Under new capital requirements, CoCo bonds can belong to the Additional Tier 1 (AT1) capital category under strict conditions. These conditions give rise to the risk of coupon can- cellation and the risk of extension beyond call dates. This study proposes two first passage- time approaches to price AT1 conversion-to-equity CoCos: a structural model adapted to AT1 CoCo pricing, and a direct model for the triggering CET1 ratio. Both models include coupon cancel risk and extension risk by setting two extra thresholds for the CET1 ratio. This study contributes to the literature by being the first to include these risk factors to first passage-time models, and one of the few to calibrate its parameters to data not including market observed CoCo prices. We find that coupon cancel and extension risk have significant impact on a CoCo’s risk profile, both driving its price down. Furthermore, we find that both models over- price CoCos for realistic values of the thresholds. This may be caused by: (i) the absence of extra downward pressure following coupon cancellation, extension, or conversion; and (ii) the absence of the risk of regulatory forced conversions. These factors provide interesting oppor- tunities for further research.