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Mathematics and Financial Economics
Erschienen in: Mathematics and Financial Economics 2/2015

01.03.2015

Valuation and analysis of zero-coupon contingent capital bonds

verfasst von: A. Metzler, R. M. Reesor

Erschienen in: Mathematics and Financial Economics | Ausgabe 2/2015

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Abstract

We consider the valuation and analysis of zero-coupon contingent capital bonds (CCBs) in the structural framework. Making virtually no assumptions on asset value dynamics, the terms of conversion or the conversion trigger, we express the value of the CCB in terms of the effective loss imposed on CCB investors at conversion and quantify the impact that contingent capital has on traditional debt and equity. We show how a variety of conversion terms can be incorporated into a single framework and describe how they can be calibrated to ensure that seniority is respected and/or equity investors are not rewarded for poor performance. We provide numerical evidence indicating that the terms of conversion can fundamentally alter the nature of the CCB, a phenomenon that is of clear interest to investors, issuers and regulators.
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Fußnoten
1
These include, but are not limited to, Lloyd’s of London (2009), Credit Suisse Group (2011) and Royal Bank of Canada (2014). See [2] for an excellent summary of global CCB issuance up to 2013.
 
2
The terms of conversion refer to the specific rules governing the exchange of debt for equity upon conversion, while the conversion trigger refers to the conditions that must be satisfied in order for conversion to occur. See [2] for terms that are frequently used in practice. According to [2] conversion triggers are almost always based on first passage of the firm’s Core Tier I Equity Ratio to a predefined lower threshold, potentially subject regulatory discretion.
 
3
In our examples we assume that conversion is triggered by the firm’s asset-liability ratio falling below a predefined threshold. By the “location of the conversion trigger” we simply mean that value of the asset-liability ratio that triggers conversion.
 
4
We motivate this feature of the model with a simple example. Suppose that firms are liquidated when they become insolvent, i.e. when the value of their assets falls below the notional value of their liabilities. Upon conversion the liabilities of the firm that uses contingent capital are reduced, which means that its asset value has farther to fall before it becomes insolvent, which means that liquidation occurs at a later date than it would have been in the absence of contingent capital.
 
5
The use of “surprise” here is not to be confused with the probabilist’s notion of unpredictability.
 
6
In the academic literature [14] and [17] consider fixed dilution factors which, in the case of coupon bonds, are equivalent to fixed conversion prices. A difference arises in the present zero coupon setting due to our definition of notional value. Our own numerical evidence indicates that for realistic parameter values there is little difference between a fixed conversion price and a fixed dilution factor.
 
7
In the academic literature fixed intended losses are considered, either implicitly or explicitly, by [1, 16], and [10]. Barucci and Viva[3] consider redemption at par, tantamount to a fixed loss of zero at conversion.
 
8
In 2011 the Office of the Superintendent of Financial Institutions, a Canadian regulator, issued an advisory on so-called non-viability contingent capital, requiring that “. . . the conversion method should take into account the hierarchy of claims . . . ”
 
9
These numbers are computed by fitting straight lines to the curves in Fig. 2 (in all cases the fits are extremely good) and looking at the magnitude of the ratio of the resulting slopes.
 
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Glasserman, P., Nouri, B.: Contingent capital with a capital-ratio trigger. Manag. Sci. 58(10), 1816 (2012)CrossRef
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Lando, D.: Credit Risk Modeling: Theory and Applications. Princeton University Press, Princeton (2004)
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Madan, D., Schoutens, W.: Conic coconuts: the pricing of contingent capital notes using conic finance. Math. Financ. Econ. 4(2), 87 (2011)CrossRefMATHMathSciNet
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Metadaten
Titel
Valuation and analysis of zero-coupon contingent capital bonds
verfasst von
A. Metzler
R. M. Reesor
Publikationsdatum
01.03.2015
Verlag
Springer Berlin Heidelberg
Erschienen in
Mathematics and Financial Economics / Ausgabe 2/2015
Print ISSN: 1862-9679
Elektronische ISSN: 1862-9660
DOI
https://doi.org/10.1007/s11579-014-0135-z