Contingent convertible lease modeling and credit risk management

Abstract

The main objective of this study is to determine a lease agreement to finance an investment project and a solution for managing credit risk. This study investigates three types of contingent leases to reduce the costs associated with bankruptcy and compensate for the lessor's position. A leasing defaultable contract allows the lessor to obtain the rent that will be recovered if the lessee defaults. A leasing convertible contract can be automatically converted into shares when certain default conditions related to the cash flows generated by the firm are met. These conditions are triggered by the ratio of the firm's value and leasing payments. A Defaultable-Convertible-Leasing contract with a payback option grants the lessor the right but not the obligation to convert the remaining lease payments into stocks or to break up the contract and pick up the rented equipment when the firm reaches the default threshold. These contracts are motivated by contributing to the range of risk-management strategies by adding more flexibility to standard leasing contracts and contingent rents. Closed-form securities pricing solutions are set forward in a dynamic model for firms with existing assets and a growth option financed by shares and a contingent lease. Risk-neutral pricing theory and the backward induction method are used to determine the pricing of corporate securities. Numerical analysis shows that leasing convertible contracts and defaultable-convertible contracts with payback options impact the service value of the leased asset, maturity, and inefficiencies resulting from insolvency and asset substitution. An optimal conversion rate reduces inefficiencies, thus making the leasing convertible contract and defaultable-convertible-leasing contract with payback option a reliable solution to ensure business continuity and loss coverage of the leasers upon default.