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Contingent capital with a dual price trigger

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  • McDonald, Robert L.

Abstract

This paper evaluates a form of contingent capital for financial institutions that converts from debt to equity if two conditions are met: the firm's stock price is at or below a trigger value and the value of a financial institutions index is also at or below a trigger value. This structure potentially protects financial firms during a crisis, when all are performing badly, but during normal times permits a bank performing badly to go bankrupt. I discuss a number of issues associated with the design of a contingent capital claim, including susceptibility to manipulation, whether conversion should be for a fixed dollar amount of shares or a fixed number of shares; uniqueness of the share price when contingent capital is outstanding; the susceptibility of different contingent capital schemes to different kinds of errors (under and over-capitalization); and the losses likely to be incurred by shareholders upon the imposition of a requirement for contingent capital. I also present an illustrative pricing example.

Suggested Citation

  • McDonald, Robert L., 2013. "Contingent capital with a dual price trigger," Journal of Financial Stability, Elsevier, vol. 9(2), pages 230-241.
    • Handle: RePEc:eee:finsta:v:9:y:2013:i:2:p:230-241
    DOI: 10.1016/j.jfs.2011.11.001
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