Conic Coconuts: The Pricing of Contingent Capital Notes Using Conic Finance

Abstract:     
In this paper we introduce a fundamental model under which we will price contingent capital notes using conic finance techniques. The model is based on more realistic balance-sheet models recognizing the fact that asset and liabilities are both risky and have been treated differently taking into account bid and ask prices in a prudent fashion. The underlying theory makes use of the concept of acceptability and distorted expectations, which we briefly discuss.

We overview some potential funded and unfunded contingent capital notes. We argue that the traditional core tier one ration is maybe not optimal, certainly when taking into account the presence of risky liabilities; we as an alternative introduce triggers based on capital shortfall. The pricing of 7 variations of funded as well as unfunded notes is overviewed. We further investigate the effect of the dilution factor and the grace factor. In an appendix we show conic balance sheets including contingent capital instruments.

Number of Pages in PDF File: 21

Keywords: Contingent capital, conic finance, acceptability, distorted expectations, capital requirements

JEL Classification: C60, G13, G3

working papers series