Valuation of Additional Tier-1 Contingent Convertible Bonds (AT1 CoCo) : Accounting for Extension Risk

Sammanfattning: The investment and financing instrument AT1, or Contingent Convertible bond, has become popular in the post-crisis capital markets, prompting interest and research in the academic world. The instrument's debt definition but equity boosting properties makes it rather extraordinary, and its stochastic features makes multiple mathematical valuation methodologies relevant, especially with regard to the risk of extending the call date of the instrument. With investors still relying on screening tools for valuation, there is an absence of applications using existing mathematical approaches. This report therefore aims to narrow the gap between academia and industry by evaluating the use of such mathematical approaches in a practical investment setting, in particular the Improved Credit Derivative approach and the Extension Premium Relative Value approach shall be examined. Both models strive to account for the extension risk, a commonly disregarded yet critical risk, adding computational challenges to the implementation. Besides from discovering necessary practical adjustments, and their effects, the two pricing approaches are compared in an attempt to confirm their joint purpose of accounting for extension risk. Ending up with varying results consisting of evident offsets for the improved credit derivative model but significant correlations in the case of the extension premium model, their individual performance was diverse while the hypothesis of joint behaviour could be dismissed.