A Reexamination of Contingent Convertibles with Stock Price Triggers

46 Pages Posted: 2 May 2016

See all articles by George Pennacchi

George Pennacchi

University of Illinois

Alexei Tchistyi

University of Illinois at Urbana-Champaign - Department of Finance

Date Written: November 2, 2015

Abstract

Initial proposals for bank contingent convertibles (CoCos) envisioned that these bonds would convert to new equity when the bank's stock price declined to a pre-specified trigger, thereby automatically re-capitalizing the bank and enhancing financial stability. However, subsequent research argued that doing so causes the bank's stock price to have multiple equilibria or no equilibrium. This paper shows that when CoCos have a perpetual maturity, which characterizes the majority of actual CoCos, a unique stock price equilibrium exists except under unrealistic conditions. A unique equilibrium can occur when conversion terms are advantageous or disadvantageous to CoCo investors and when CoCos convert to new equity shares or are written down. Moreover, the existence of a unique equilibrium stock price is more likely when the bank's asset risk is higher, when there are direct costs of bankruptcy, and when CoCos are callable by the bank. We illustrate these results by developing models of CoCos with either perpetual or finite maturities that lead to closed-form solutions for stock and CoCo values.

Keywords: CoCos, equilibrium

Suggested Citation

Pennacchi, George G. and Tchistyi, Alexei, A Reexamination of Contingent Convertibles with Stock Price Triggers (November 2, 2015). Available at SSRN: https://ssrn.com/abstract=2773335 or http://dx.doi.org/10.2139/ssrn.2773335

George G. Pennacchi

University of Illinois ( email )

4041 BIF, Box 25
515 East Gregory Drive
Champaign, IL 61820
United States
217-244-0952 (Phone)

HOME PAGE: http://www.business.illinois.edu/gpennacc/

Alexei Tchistyi (Contact Author)

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States

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