Investigation of the European Banks' CoCo Bonds Pricing

The paper examines the correlation dynamics among three asset classes from European Banks’ capital structure: equity (Stocks), conventional bonds (Bonds) and contingent convertible bonds (CoCos). Using the dataset with on daily security prices of 7 European banks, the paper illustrates that – apart from Spanish banks, considered separately – the three classes of securities tend to become more correlated as market uncertainty – represented by VIX index – grows. On the contrary, with market sentiment on the positive side and lower volatility levels, the three security classes tend to become less correlated. The conclusion is being vividly supported by the COVID-19 price actions, that have been partially covered by the dataset. It was also discovered that log return of country’s’ stock market index is negatively related to all three pairs of correlations, with bigger effect on correlation of CoCo-stock, implying that increase in index leads to a more sizable decrease in correlation of CoCo with stock than correlation of CoCo and bond. Moreover, across the quantiles of log return of the stock market index, mean correlation between CoCo and stock is much higher than correlation between CoCo and bond. This conclusion holds for all the observed banks. All these observations suggest that contingent convertible bonds are closer to equities in their behavior. An additional study has been performed to investigate the effect of banking and macroeconomic variables on the correlations mentioned above. It was found that Capital Adequacy Ratio, Tangible Common Equity to Risk weighted Assets ratio, ZEW Index on European expectation of economic growth were negatively related to correlation of CoCo-stock, while Loans to Asset ratio and ZEW Index on European expectation of inflation were positively related to the correlation between CoCo and stock. No statistical evidence was found on significance of the effect of CPI and GDP growth on CoCo-stock correlation. No indicator from abovementioned was found to be significant for CoCo-bond correlation.