Contingent Capital and Calibration of Capital Structure Models

Why Study Contingent Capital?

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). Much of this interest has been in contingent capital, in the form of 

contingent convertible capital instruments (CoCos).

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.

Areas of Exploration

Capital Structure Models

Includes developing and calibrating models that are used as tools for assessing the credit-worthiness of borrowers. These facilitate the valuation and analysis of corporate securities, and the investigation of other issues of interest in corporate finance. 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. This drives the need for methods of model calibration or parameter estimation using observable information. The calibration/estimation scheme dictates what observable data to use and also how to use it.

*Observable information can include historical stock prices, equity option prices, bond prices (credit spreads), and credit-default swap prices. 

Solving Global Challenges

Research Team’s Goal

To develop more sophisticated and realistic capital structure models for firms having contingent capital. Also to adopt methods for calibrating these models, with and without the presence of CoCos.

Area of Impact

​​Results of this research will be of interest to academics and practitioners who work with capital structure models. 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.