Pricing Under Endogenous Capital Structure Changes and Discontinuous Trading
51 Pages Posted: 1 Oct 2018
Date Written: September 1, 2018
We provide sufficient and necessary conditions for the unique net present valuation of assets with ambiguous cash-flows that are not in a unidirectional causal relationship with the capital structure of the issuing firm. Recent literature has shown that the net present valuation of such assets is not generally unique if trading is discontinuous. Prominent examples are the assets of a firm issuing Contingent Convertible bonds (CoCos) that convert based on the trading prices of the firm's equity. These bonds have been proposed as automatic recapitalization tools for large banks to enhance financial stability. Our policy recommendation to the CoCo regulatory framework is to ensure that investors know the probability of a liquidity-induced change of the firm's capital structure. This results in the uniqueness of the asset net present valuation. Our analysis is solely based on the distinction between net present valuation and trading price and fundamental economic laws of asset demand. We illustrate the uniqueness of the net present valuation in cases of CoCos that are converted when the firm's equity trading price declines to a predetermined level, and for capital structure changes favoring either equity or debt holders.
Keywords: Endogenous Demand, Discontinuous Trading, Capital Structure, Contingent Convertible Debt, Financial Stability
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