Collaborative Research Team Project #14
Contingent Capital and Calibration of Capital Structure Models
This project explores contingent capital, CoCos and the calibration of capital structure models.
Research Category: Information Sciences
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.
CoCos are instruments that are debt (or preferred shares) when issued and that convert to common equity when the issuing FI is in financial distress. Conversion has the effect of re-capitalizing the FI, exactly when it would be most difficult for them to raise funds in capital markets through the issuance of new securities.
Conversion also dilutes the ownership stake of the pre-conversion shareholders. This may potentially curb excessive risk taking in the financial industry, as losses will be imposed on the firm’s investors, rather than taxpayers.
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.
People Behind the Project
Mark Reesor | Wilfrid Laurier University
Adam Metzler | Wilfrid Laurier University
Hatem Ben-Ameur | HEC Montréal
Joe Campolieti | Wilfrid Laurier University
Pascal François | HEC Montréal
Lars Stentoft | Western University
Xinghua (Alan) Zhou | Morgan Stanley, New York
Find Related Programs
Contingent Capital and Calibration of Capital Structure Models is a Collaborative Research Team project. This program tackles complex problems through a three-year research and training agenda.
CANSSI offers approximately $200,000 for this type of project, which requires a team of faculty, postdocs, and students.