A structural framework for modelling contingent capital

This paper develops a structural model of contingent capital. In contrast to existing approaches we explicitly link the firm’s total payout to its cost of debt, leading to a total payout that is linear in—as opposed to proportional to—asset value. In the special case that asset value evolves as affine geometric Brownian motion we derive closed-form expressions for limiting (i.e. perpetual) bond values. The proposed model is flexible, so that it can be used to gauge the relative merits of different variations of contingent capital, and parsimonious, so that it is relatively easy to implement in practice. An empirical example using data from the Canadian banking sector is provided that illustrates how the model can generate insights into problems that are of interest to both regulators and issuers of contingent capital (e.g. what range of conversion prices would be consistent with regulatory guidelines, and how expensive is contingent debt over this range).     

Pricing contingent convertibles: a general framework for application in practice

The first contingent convertibles (CoCo) were issued in 2009, but, to date, the academic community has not given much attention to practical issues of pricing them. Combining various aspects from existing theoretical and practical literature, this paper first presents a CoCo pricing framework that allows a flexible and comprehensible valuation of real-world equity or TIER-1 ratio-triggered CoCos. The model is based on the assumption that the issuer’s total asset value follows a Brownian motion, that book values reflect fair economic values in the case of financial distress, and that there is a linear relationship between straight equity and TIER-1 ratios. The pricing methodology is then applied to the Credit Suisse Buffer Capital Note issued in February 2011.     

Close form pricing formulas for Coupon Cancellable CoCos

Contingent Convertibles (“CoCos”) are contingent capital instruments which convert into shares, or have a principal write down, if a trigger event takes place. CoCos exhibit the undesirable so-called death-spiral effect: by actively hedging the equity risk, investors can (unintentionally) force the conversion by making the share price deteriorate and eventually trigger the conversion.In this paper we introduce and analyse Coupon Cancellable CoCos (“CoCa CoCos”), a new type of CoCo where coupons can be cancelled during the lifetime of the note. We provide closed-form pricing formulas for CoCa CoCos, we study the impact of coupon cancellations in the price of the bond and we show that death-spiral effect is reduced.     

An evaluation of contingent immunization

This paper tests the effectiveness of contingent immunization, a stop loss strategy that allows portfolio managers to take advantage of their ability to forecast interest rate movements as long as their forecasts are successful, but switches to a pure immunization strategy should the stop loss limit be encountered. This study uses actual daily transactions in the Spanish Treasury market covering the period 1993–2003 and uses performance measures that accounts for skewness and kurtosis as well as mean variance. The main result of this paper is that contingent immunization provides excellent performance despite its simplicity.     

Global modelling revisited

Reasons for the great impact of World Dynamics and Limits to Growth include their addressing the correct audience (the public), and the ability of systems dynamics clearly to handle and communicate information on complex and often little understood areas. Modelling projects should usually be global or national (not regional), draw heavily on mental and not just written and numerical databases, and have time horizons of perhaps 100 years. Sadly, critics of Worlds 2 and 3 have yet to come to grips with the fundamental messages presented there, although these messages are becoming increasingly vital.     

A recursive method for static replication of autocallable structured products

This paper discusses the problem of valuation and risk management of structured products, which have been popular in recent financial markets. We propose a recursive method based on static replication for a variety of structured products, and, in particular, focus on products with autocallable and barrier features under a general Markovian diffusion with killing. The core idea of the proposed algorithm is to recursively utilize the strike-spread approach and calendar-spread approach in the literature. To increase computational and practical feasibilities, we devise discrete static hedges and their convergence is analysed. Numerical experiments are conducted to confirm the effectiveness of our proposal and to show its highly accurate pricing and hedging performance.     

Bayesian approach to yield curve modelling with application to the simulation of EMU environments: generating scenarios by modelling yield curve movements

A Bayesian approach to yield curve modelling is developed where information on the current and recent yield curves is used to generate yield curve scenarios, and a model is proposed that generates return distribution for bonds. The predictive power of the model is developed by comparing out-of-sample lagged realized yields with forecast yields, and it is demonstrated that the returns generated by this scenario approach and those generated using the standard time series approach are consistent. The model is applied to pre-EMU and post-EMU environments. This paper assesses the implications of different assumptions on the early post-EMU environment for international bond portfolio selection, as well as the immediate short-term effect of EMU on risk and return.     

Lessons from global modelling and modellers

Two key lessons arising from ten years of global modelling are, first, that there are indeed lessons to be learned—eg ‘business as usual’ is not a viable world future, but the will to change economic, political and social structures could indeed create a decent and sustainable standard of living for all; second, many of the lessons are fairly obvious, but there is a great reluctance, even amongst global modellers, to take them into account—eg the real-world importance of politics is rarely represented in models, or the need to take great care not to mislead when publicizing results.     

Spatial statistical modelling of insurance risk: a spatial epidemiological approach to car insurance

Spatial models, such as the Besag, York and Mollie (BYM) model, have long been used in epidemiology and disease mapping. A common research question in these subjects is modelling the number of disease events per region; here the BYM models provides a holistic framework for both covariates and dependencies between regions. We use these tools to assess the relative insurance risk associated with the policyholders geographical location. A Bayesian modelling approach is presented and an elastic net is used to reduce the large number of possible geographic covariates. The final inference is performed using Integrated Nested Laplace Approximation. The model is applied to car insurance data from If P&C Insurance together with spatially referenced covariate data of high resolution, provided by Insightone. The entire analysis is performed using freely available R-packages. Including spatial dependence when modelling the number of claims significantly improves on the result obtained using ordinary generalised linear models. However, the support for adding a spatial component to the model for claims cost is weaker.     

Hazard rate for credit risk and hedging defaultable contingent claims

We provide a concise exposition of theoretical results that appear in modeling default time as a random time, we study in details the invariance martingale property and we establish a representation theorem which leads, in a complete market setting, to the hedging portfolio of a vulnerable claim. Our main result is that, to hedge a defaultable claim one has to invest the value of this contingent claim in the defaultable zero-coupon.Received: April 2003Mathematics Subject Classification: 91B24, 91B29, 60G46JEL Classification: G10The authors would like to thank D. Becherer and J.N. Hugonnier for interesting discussions and the anonymous referee whose pertinent questions on the first version of this paper help them to clarify the proofs. All remaining errors are ours.     

Upfront versus rating contingent fees: Implications for rating quality

This paper theoretically investigates whether compensating a credit rating agency (CRA) with an upfront fee, rather than a rating contingent fee, can improve rating quality. I show that an upfront fee delivers the same rating quality as the rating contingent fee if the CRA sets its rating policy before the issuer solicits a rating, whereas it can potentially improve quality if the rating policy is set only after a rating is solicited. These results suggest that the “Franken Amendment” that has been removed from the Dodd-Frank Act might be crucial for the proposed upfront fee regime to improve rating quality.     

A content analysis of the comment letters to the FASB and IASB: Accounting for contingencies

In this study, we read and analyze 369 comment letters written in response to the IASB's Exposure Draft (ED) of Proposed Amendments to IAS 37 and the FASB's Exposure Draft of Proposed Amendments to FASB Statement No. 5. We also examine how responses to the IASB ED are affected by whether or not the use of IFRS is mandated or permitted by the respondent's country. Although responses were overwhelmingly unfavorable to both EDs, more support was shown for the IASB's proposal to eliminate the probability recognition criterion than for the FASB's proposal to amend the U.S. GAAP disclosure rules. Users responding to the FASB ED provided significantly more intense support than corporate preparers, financial preparers, and legal practitioners. Significantly more respondents to the IASB ED were from countries required or permitted to use IFRS than from countries required to report under their national GAAP. In addition, constituents required or permitted to use IFRS were significantly more likely to express an unfavorable response to the ED and to cite relevance to support their position.     

Capital Budgeting for Advertising Expenditures: A Contingent Claims Approach

Advertising expenditures constitute a big part of the budgets of firms. Through their impact on demand and costs, advertising activities affect the firm's pricing and output decisions as well as the firm's market value. Yet, there is no analytical framework by which these effects can be measured. This paper develops a cash flow model for a product where the advertising budget is divided between a strategic component designed to increase expected demand and a contingent component allocated to be used only if sales fall short of capacity. Contingent claims techniques are employed to evaluate the present value of the cash flows and to provide a framework for determining the size of the advertising budget, and the pricing and production strategies that maximize the firm's value. The impact of the price sensitivity, volatility, and growth rate of demand on the size of the advertising budget is also analyzed.     

A contingent claim analysis of closed-end fund premia

We estimate contingent claims that replicate monthly net asset value (NAV) payoffs from closed-end funds. A claim's theoretical value is obtained by martingale pricing methods. The resulting net present value (NPVS) sequence is the theoretical premia sequence that is compared to the actual market premia sequence. The theoretical premia, like actual premia, are uncorrelated with NAV returns and are positively autocorrelated due to autocorrelation in the pricing information. However, there is poor correspondence between the theoretical and actual premia that seems due to the market's systematic errors in estimating a fund's management value. Risky arbitrage may be available to insiders.     

Explicit tests of contingent claims models of mortgage default

This paper provides explicit and powerful tests of contingent claims approaches to modeling mortgage default. We investigate a model of frictionless default (i.e., one in which transactions costs, reputation costs, and moving costs play no role) and analyze its implications-the relationship between equity and default, the timing of default, its dependence upon initial conditions, and the severity of losses. Absent transactions costs and other market imperfections, economic theory makes well-defined predictions about these various outcomes.The empirical analysis is based upon two particularly rich bodies of micro data: one indicating the default and loss experience of all mortgages purchased by the Federal Home Mortgage Corporation (Freddie Mac), and a large sample of all repeat sales of single family houses whose mortgages were purchased by Freddie Mac since 1976.