A Simulation-Based Approach to Pricing Sovereign CoCos

Abstract

Sovereign CoCos have been proposed as a way to eliminate the high cost of sovereign debt restructuring and credibly manage the debt overhang problem in Europe. This paper presents a simple simulation-based pricing model to nd the theoretical value of sovereign CoCos. I run several robustness tests, nding the e ects of scal discipline, of the initial share of CoCos as a fraction of total debt, and of using a multivariate normal distribution instead of a VAR to describe the data, on the price of contingent and non-contingent debt. I also nd a theoretical price for GDP-linked bonds, another sovereign contingent debt instrument, and compare their properties to those of sovereign CoCos. I nd that the introduction of sovereign CoCos reduces the probability of default on non-contingent debt and reduces also the total cost of restructuring by more e ciently distributing default risk. The hope is that by nding a theoretical value for sovereign CoCos, this paper will generate market interest in sovereign CoCos and provide academics with a quantitative foundation from which to continue to add to the literature on the sovereign CoCo.