Contingent Capital and Calibration of Capital Structure Models

Collaborative Research Team Project: 2019-2022

Since the 2008 financial crisis there has been renewed interest by governments and regulators to find ways to avoid taxpayer-funded bailouts of financial institutions (FI), with contingent capital (CoCo) garnering much of this interest. CoCos are instruments that are debt (or preferred shares) when issued and that convert to common equity when the issuing FI is in financial distress. Conversion has the effect of re-capitalizing the FI exactly when it would be most difficult for them to raise funds in capital markets through the issuance of new securities. Additionally, conversion dilutes the ownership stake of the pre-conversion shareholders and may potentially curb excessive risk taking in the financial industry as losses will be imposed on the firm’s investors, rather than taxpayers.

Firms finance their operations through the issuance of corporate securities, such as bonds and common shares, which constitute a firm’s capital structure. International banking regulations (Basel III) and individual jurisdictions, including Canada, now require FIs to issue CoCos as part of their capital structure. Since the early 1970s capital structure models have been used as a main tool to assess the credit worthiness of borrowers.  These models specify a stochastic process for firm-value evolution and corporate securities are viewed as contingent claims on firm value. Capital structure models facilitate the valuation and analysis of corporate securities and for the investigation of other issues of interest in corporate finance (e.g., what proportion of equity and debt is optimal). The valuation methodology depends crucially on the process driving firm value and the types of securities issued by the firm.

One issue with capital structure models is that firm value is unobservable, hence driving the need for methods of model calibration/parameter estimation using observable information. This observable information can include historical stock prices, equity option prices, bond prices (credit spreads), and credit-default swap prices. The calibration/parameter estimation scheme dictates what observable data to use and also how to use it. The main goals of this project are to

  1. Develop more sophisticated and hence realistic capital structure models for firms having contingent capital; and
  2. Adopt methods for calibrating these models, both with and without the presence of Cocos.

Results of this research will be of interest to academics and practitioners who work with capital structure models and, since these models are inputs into models used for assessing credit risk, the impact can be widespread. These results will be relevant to the assessment of counterparty credit risk (including credit- and debit-value adjustments); to Coco issuers and investors; and to financial regulators and policymakers.

The team leaders are Mark Reesor and Adam Metzler of Wilfrid Laurier and Hatem Ben-Ameur of HEC Montreal. Collaborators include Joe Campolieti of Wilfrid Laurier, Pascal Francois of HEC Montreal, Lars Stentoft of Western, and Xinghua (Alan) Zhou of Morgan Stanley, New York.

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