The Handbook of Hybrid Securities Convertible Bonds, CoCo Bonds, and Bail-In

To an equity trader they are shares. For the trader at the fixed income desk, they are bonds (after all, they pay coupons, so what's the problem?). They are hybrid securities. Neither equity nor debt, they possess characteristics of both, and carry unique risks that cannot be ignored, but are often woefully misunderstood. The first and only book of its kind, The Handbook of Hybrid Securities dispels the many myths and misconceptions about hybrid securities and arms you with a quantitative, practical approach to dealing with them from a valuation and risk management point of view.

• Describes a unique, quantitative approach to hybrid valuation and risk management that uses new structural and multi-factor models
• Provides strategies for the full range of hybrid asset classes, including convertible bonds, preferreds, trust preferreds, contingent convertibles, bonds labeled "additional Tier 1," and more
• Offers an expert review of current regulatory climate regarding hybrids, globally, and explores likely political developments and their potential impact on the hybrid market
• The most up-to-date, in-depth book on the subject, this is a valuable working resource for traders, analysts and risk managers, and a indispensable reference for regulators

Jan De Spiegeleer (Geneva, Switzerland) is head of risk management at Jabre Capital Partners, a Geneva-based hedge fund. He earned an extensive knowledge of derivatives pricing, hedging and trading while working for KBC Financial Products in London, where he was managing director of the equity derivatives desk. He also ran his own market neutral statistical arbitrage hedge fund (EQM Europe) after founding Erasmus capital in 2004. Prior to this financial career, Jan served ten years in the Belgian Army as an Officer. With Wim Schoutens he co-authored the Handbook of Convertible Bonds published by Wiley.

Cynthia Van Hulle (Leuven, Belgium) is a full professor of Finance at the Department of Accounting, Finance and Insurance of the Faculty of Economics and Business at the Catholic University of Leuven. Over the last 20 years she has acquired extensive practical experience through her board memberships in the financial sector and organization of in-company training programs. She has published considerably in scientific journals a.o. Journal of Banking and Finance, Journal of Finance, Journal of Corporate Finance, European Financial Management, Journal of Business Research, Journal of Business, Finance and Accounting, Small Business Economics. She also held the Francqui-chair and is co-author of several books in corporate finance.

Wim Schoutens (Leuven, Belgium) is a research professor in financial engineering at the Department of Mathematics at the Catholic University of Leuven, Belgium. He has extensive practical experience of model implementation and is well known for his consulting work to the banking industry and other institutions. In particular, he is an independent expert advisor to the European Commission (DG-COMP) on impaired assets and asset relief measures and has assessed in that position more than EUR 1 trillion of assets; in particular he was one of the main expert advisors for the stress test on the Spanish banks and the related bailouts. Wim is also the author of several books including Contingent Convertibles (CoCos): Structure and Pricing, the first book ever on Contingent Capital and CoCo bonds (written together with Jan De Spiegeleer). He is Managing Editor of the International Journal of Theoretical and Applied Finance and Associate Editor of Mathematical Finance, Quantitative Finance and Review of Derivatives Research. Finally, he is member of the Belgium CPI commission and independent director of the Board of Assénagon Asset Management S.A.

1 Hybrid Assets 1

1.1 Introduction 1

1.2 Hybrid Capital 1

1.3 Preferreds 4

1.4 Convertible Bonds 7

1.5 Contingent Convertibles 9

1.6 Other Types of Hybrid Debt 10

1.7 Regulation 20

1.8 Bail-In Capital 22

1.9 Risk and Rating 24

1.10 Conclusion 25

2 Convertible Bonds 27

2.1 Introduction 27

2.2 Anatomy of a Convertible Bond 30

2.3 Convertible Bond Arbitrage 51

2.4 Standard Features 65

2.5 Additional Features 82

2.6 Other Convertible Bond Types 88

2.7 Convertible Bond Terminology 95

2.8 Convertible Bond Market 102

2.9 Conclusion 106

3 Contingent Convertibles (CoCos) 107

3.1 Introduction 107

3.2 Definition 109

3.3 Anatomy 110

3.4 CoCos and Convertible Bonds 121

3.5 CoCos and Regulations 125

3.6 Ranking in the Balance Sheet 150

3.7 Alternative Structures 151

3.8 Contingent Capital : Pro and Contra 152

4 Corporate Hybrids 159

4.1 Introduction 159

4.2 Issuer of Hybrid Debt 160

4.3 Investing in Hybrid Debt 160

4.4 Structure of a Corporate Hybrid Bond 161

4.5 View of Rating Agencies  170

4.6 Risk in Hybrid Bonds 170

4.7 Convexity In Hybrid Bonds 173

4.8 Equity Character of Hybrid Bonds 177

5 Bail-in Bonds 181

5.1 Introduction 181

5.2 Definition 183

5.3 Resolution Regime 184

5.4 Case Studies 191

5.5 Consequences of Bail-in 195

5.6 Conclusion 197

6 Modeling Hybrids : An Introduction 199

6.1 Introduction 199

6.2 Heuristic Approaches 200

6.3 Building Models 205

6.4 How many factors ? 213

6.5 Sensitivity Analysis 217

7 Modeling Hybrids: Stochastic Processes 225

7.1 Introduction 225

7.2 Probability Density Functions 226

7.3 Brownian Motion 232

7.4 Ito Process 233

7.5 Poisson Process 243

8 Modeling Hybrids : Risk Neutrality 251

8.1 Introduction 251

8.2 Closed Form Solution 255

8.3 Tree-based methods 264

8.4 Finite Di↵erence Technique 289

8.5 Monte Carlo 290

9 Modeling Hybrids: Advanced Issues 299

9.1 Tail Risk in Hybrids 299

9.2 Jump-Di↵usion 301

9.3 Correlation 323

9.4 Structural Models 337

9.5 Conclusion 340

10 Modeling Hybrids : Handling Credit 343

10.1 Credit Spread 343

10.2 Default Intensity 348

10.3 Credit Default Swaps 350

10.4 Credit Triangle 365

10.5 Stochastic Credit 370

11 Constant Elasticity of Variance (CEV) 373

11.1 From Black-Scholes to CEV 373

11.2 Historical Parameter Estimation 378

11.3 Valuation : Analytical Solution 383

11.4 Valuation : Trinomial Trees for CEV 386

11.5 Jump-Extended CEV Process 394

11.6 Case Study : Pricing Mandatories with CEV 398

11.7 Case Study : Pricing Convertibles with a Reset 400

11.8 Calibration of CEV 410

12 Pricing Contingent Debt 417

12.1 Introduction 417

12.2 Credit Derivatives Method 418

12.3 Equity Derivatives Method 425

12.4 Coupon Deferral 439

12.5 Using Lattice Models 445

12.6 Linking Credit to Equity 447

12.7 CoCos with Upside : CoCoCo 455

12.8 Adding Stochastic Credit 460

12.9 Avoiding Death Spirals 467

12.10Appendix : Pricing Contingent Debt on a Trinomial Tree 470

13 Multi-Factor Models for Hybrids 479

13.1 Introduction 479

13.2 Early Exercise 481

13.3 American Monte Carlo 486

13.4 Multi-Factor Models 501

13.5 Conclusion 511

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