Revue of contingent capital pricing model using growth and barrier option approach with numerical application

Abstract

This paper investigates the effects of contingent capital, a debt instrument that automatically converts into equity if the value of the asset is below a predetermined threshold on the pricing process of a bank assets’. A traceable form of the contingent convertible bond is analyzed to find a closed-form solution for the price of this bond using barrier and growth options. We examine the interaction between growth options and financing policy in a dynamic business model. The contribution of this paper is to extend Hilscher and Raviv [10] and Tan and Yang [22] research to include the evaluation of all aspects of banks' financial structure, with an emphasis on explicitly calculating the likelihood of the default event. The fundamental theorem of asset pricing and the first passage of time method have been used to generate closed formulas that are amenable to practical analysis. The potential benefits from contingent capital as financing and risk management instrument can be assessed through their contribution to reducing the probability of default. The appropriate choice of contingent capital parameters, the rate, and the conversion threshold can reduce shareholders incentives to change risk.

Keywords

• contingent capital
• capital structure
• banking regulation
• default probability
• real option
• risk incentive