Coast to Coast Seminar Series: "Analysis of Contingent Capital Bonds in Merton-type Structural Models"

Tuesday, March 1, 2011
11:30 - 12:30

Dr. Adam Metzler
Department of Applied Mathematics, University of Western Ontario


ontingent capital bonds (CCB) are securities which "begin life" as subordinated debt, and convert to equity if the issuing firm becomes financially distressed. CCB have recently begun to attract attention as a means to shift the cost of supporting distressed financial institutions from taxpayers to shareholders, thereby enforcing "market-based" discipline. At the present time, however, the discussion surrounding CCB has been largely heuristic. In this talk we attempt, via Merton-type structural models, to shed theoretical light on two fundamental issues regarding CCB. The first is their cost (i.e. par yield), which we find to be surprisingly cheap. Indeed overall debt costs are reduced when CCB are introduced to the capital structure. The second issue we investigate is how CCB respond to changes in fundamental parameters such as leverage and volatility. We find that the answer to this question depends critically on the conversion price, and different prices (for example fixed versus market-based) lead to radically different behaviour.

Joint work with R. Mark Reesor, Applied Mathematics, University of Western Ontario