A Two-Factor Contingent Convertible Bond Pricing Model with Calibrated Option Adjusted Spread

We construct a two-factor pricing model for contingent convertible bonds having a conversion to equity loss absorption mechanism, triggered by the event of the issuer’s Tier 1 ratio falling below a pre-determined level. The two stochastic factors are the issuer’s equity price and Tier 1 ratio. A key feature of the model is its calibration to market using an option adjusted spread parameter. Using a Taylor approximation we assess the model’s explanatory power to decompose returns and attribute them to various risk factors, most notably those factors directly related to the issuer’s equity