Contingent Capital Pricing Model and Default Probability in the Banking Industry

Abstract

This paper is based on the study of Hilscher and Raviv (2014) and Tan and Yang (2015) to investigate 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 represent its characteristics and examine the interaction between growth options and financing policy in a dynamic business model. We study how the contingent capital can be an effective tool for elaborating investment program, capital structure mix and stabilizing financial institutions. The potential benefits from contingent capital as financing and risk management instrument can be assessed through their contribution to reducing the probability of default associated to the subordinated debt. The appropriate choice of contingent capital parameters, the rate, and the conversion threshold can reduce shareholders incentives to change risk.