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|Title||Can the attractiveness of Contingent Convertible bonds be explained by investors exhibiting systematic behavioral biases?|
|Institution||University of Zurich|
|Faculty||Faculty of Economics, Business Administration and Information Technology|
|Zusammenfassung||A contingent convertible (CoCo) bond is a bond that converts into equity of the issuing bank upon the occurrence of a predefined trigger event. It is, therefore, defined as a hybrid security. In 2011, Credit Suisse was the first to issue a CoCo bond to meet the heightened Basel III equity capital standards. The market for CoCo bonds is still new and relatively small. However, it is growing. Given the new Basel III accord and the benevolent tax treatment of CoCo bonds, the supply side of the market has been greatly motivated to issue the new contingent capital. On the demand side, investors wholeheartedly accepted this new hybrid security in the market. The CoCo bond issuances of banks, such as Credit Suisse, the UBS or Deutsche Bank, were oversubscribed several times over. However, the payoff profile of a CoCo bond is similar to a barrier reverse convertible, which is a highly complex, yet popular, structured product (SP). Studies have shown that the attractiveness of this SP is explained by the fact that investors exhibit a bias in their risk assessment and systemically underestimate the risk. This study investigates whether the attractiveness of the CoCo bond originates from an analogous biased judgment of investors, given the similarity between the CoCo bond’s and the barrier reverse convertible’s payoff profile. For the analysis, a CoCo bond issued by a Swiss Financial Institution within the last 5 years, was used. As of March 21, 2014, Reuters published two prices for the CoCo bond: a fair price and a lower market price. It was investigated whether the source of this mispricing could be attributed to rational or biased investors. More specifically, the influence of the availability, anchoring and overconfidence bias on investors’ judgment of the CoCo bond was examined. A survey was conducted among investors; the survey questions were based on an anonymized factsheet of the CoCo bond. In the first part of the survey, the participants were asked a series of diagnostic questions to determine whether they exhibited one or more of the three above-mentioned biases. In a second part of the survey, the participants were asked to estimate key variables of the CoCo bond, based on the information provided on the factsheet. The estimates were subsequently compared to the true CoCo bond values, which were derived with the use of two pricing models. The key variables of the CoCo bond included the conversion probability, the share price upon the trigger event and the corresponding recovery rate. Data obtained from 101 survey participants were collected and analyzed. Thirty-eight participants fit the criteria of institutional investors, whereas the remaining 63 participants formed the non-institutional investor group. Participants were considered biased if they exhibited two or three biases. Otherwise, they were considered unbiased. The results showed that both institutional and non-institutional investors misestimated the share price trigger level and the recovery rate. The conversion probability of the BCN was correctly estimated within both groups. On this aggregate level, no substantial difference was detected between biased and unbiased investors within the two investor groups. The calculated expected loss showed that all investor groups significantly underestimated the loss in the case of a conversion. Because of its complex structure, the CoCo bonds are mainly intended for institutional investors. However, the survey found evidence that the expected loss underestimation was as severe for institutional investors as it was for non-institutional investors. The single bias analysis provided more insight into the effects of the individual biases. Overall, biased and unbiased institutional investors showed a high difference between their respective estimates of the BCN values. The conversion probability estimates of the institutional investors with an availability or a certainty overconfidence bias were significantly lower than the estimates of the unbiased investors. Furthermore, the data supported the theory that the BCN’s floor price of CHF 20 acts as an anchor. Anchoring biased institutional investors gave a share price estimate that was closer to the floor price than the unbiased investors. The prediction overconfident investors indicated a significantly higher level of confidence in their estimate of the BCN’s recovery rate. However, their recovery rate estimates were worse than those of the unbiased investors, such that their heightened trust in their own abilities created a fatal blind spot in their risk assessment of CoCo bonds. There was little evidence that individual biases affected the risk assessments of non-institutional investors. A possible explanation is that the estimates of the non-institutional investors were more distorted by additional factors that were not considered in this study. Hence, it became increasingly difficult to detect a possible effect on the risk assessments of this group of investors. In general, the somewhat severe misestimates in the survey proved that further research on the effects of behavioral biases is needed.|