A Model of Deferred Callability in Defaultable Debt

Banks and other financial institutions raise hybrid capital as part of their risk capital. Hybrid capital has no maturity, but, similarily to most corporate debt, includes an embedded issuer's call option. To obtain acceptance as risk capital, the first possible exercise date of the embedded call is contractually deferred by several years, generating a protection period. The existence of this call feature affects the issuer's optimal bankruptcy decision, in addition to the value of debt. We value the call feature as a European option on perpetual defaultable debt. We do this by first modifying the underlying asset process to incorporate a time dependent bankruptcy level before the expiration of the embedded option. We identify a call option on debt as a fixed number of put options using a modified exercise price on a modified asset, which is lognormally distributed, as opposed to the market value of debt. To include the possibility of default before the expiration of the option we apply barrier options results. The formulas are quite general and may be used for valuing both embedded and third-party options. All formulas are developed in the seminal and standard Black-Scholes-Merton model and, thus, standard analytical tools such as 'the greeks', are immediately available.Callable perpetual debt; barrier options

A valuation model of deferred callability in defaultable debt

In this thesis a model is developed for valuing risky perpetual debt with an embedded American call option that can be exercised after a protection period. These features are relevant for a hybrid capital instrument typically issued by banks and other financial institutions, partly as an outcome of regulatory requirements. There exist a large market for this instrument, the outstanding amount of hybrid capital securities was $ 376 billion in 2005 (Mjøs and Persson, 2007). The model is based on a model by Mjøs and Persson (2010) where similar debt is valued, but where as a simplification the option is assumed to be a European type of option. Market practice indicates that this hybrid capital instrument is issued with an American option and a step-up coupon rate, in this sense the model developed in this thesis is more realistic than Mjøs and Persson’s model because it incorporates these characteristics. An important result from this thesis is that the value of risky perpetual debt with an embedded American call option differs from the value of similar debt with a European call option. This is interesting because considering market practice and the characteristics of the two options would imply otherwise

Assessing market discipline in UK credit institutions: subordinated debt holders as signallers of bank risk

The thesis examines subordinated debt holder market discipline in UK credit institutions during the period 1995 to 2002. The topic is relevant as current research is questioning the role and effectiveness of rules-based bank regulatory oversight, and favouring, instead, incentive-compatible regulatory design and market discipline. In particular, the literature proposes using signals from subordinated debt holders to constrain bank risk-taking. In addition, this market oversight may provide information signals to regulatory agencies that are useful in improving bank regulatory design. The thesis researches two prominent issues related to subordinated debt holder market discipline and, therefore, contributes to the debate in introducing incentive-compatible polices in bank regulatory design. First, testing the risk sensitivity of UK credit institution subordinated debt spreads assesses whether investors are signalling bank risk in market prices. The UK evidence supports the theoretical literature in claiming that eliminating too-big-to-fail policies can encourage effective incentive-based mechanisms. Secondly, the research examines the appropriateness of introducing a mandatory subordinated debt policy in the UK. The empirical analysis raises a number of themes, many of which are in stark contrast to US and other European banks' subordinated debt characteristics. The conclusion is that the regular issuance of subordinated debt should be the overriding policy tool to signal and constrain bank risk-taking (i.e. direct discipline). Extending the policy to include indirect market discipline through a standardised mandatory subordinated debt requirement would impose substantial costs and should not be implemented

The Valuation of Corporate Debt with Default Risk

This article values equity and corporate debt by taking into account the fact that in practice the default point differs from the liquidation point and that it might be in the creditors' interest to delay liquidation. The article develops a continuous time asset pricing model of debt restructuring which explicitly considers the inalienability of human capital. The study finds that even though in general the creditors will not liquidate the firm on the incidence of default, but nevertheless would liquidate the firm prematurely relative to the first best threshold. This agency problem leads to the breakdown of the capital structure irrelevance result.Debt pricing, default risk, inalienability of human capital

Global Evaluation of Contingent Convertibles: Testing for Evidence of Market Discipline in the CoCo Market

In this paper, we investigate evidence of market discipline from contingent convertible (CoCo) issues. Previous research has focused on the monitoring aspect of market discipline, by testing risk sensitivity of market prices (subordinated notes and debentures (SND)) to accounting measures of bank risk. We take a similar approach using CoCo spreads and additionally use issue specific features. We analyze the CoCo market from the first issue in 2009 to Q1 2014, covering a sample of 118 contingent convertibles. Our findings provide evidence of market discipline, suggesting that investors are sensitive to the risk profile of the issuing bank. Moreover, several features incorporated in the contracts prove to have a significant relationship to the spread of these instruments

Structural models for the pricing of corporate securities and financial synergies. Applications with stochastic processes including arithmetic Brownian motion.

Mergers are the combining of two or more firms to create synergies. These synergies may come from various sources such as operational synergies come from economies of scale or financial synergies come from increased value of securities of the firm. There are vast amount of studies analysing operational synergies of mergers. This study analyses the financial ones. This way the dynamics of purely financial synergies can be revealed. Purely financial synergies can be transformed into financial instruments such as securitization. While analysing financial synergies the puzzle of distribution of financial synergies between claimholders is investigated. Previous literature on mergers showed that bondholders may gain more than existing shareholders of the merging firms. This may become rather controversial. A merger may be synergistic but it does not necessarily mean that shareholders¿ wealth will increase. Managers and/or shareholders are the parties making the merger decision. If managers are acting to the best interest of shareholders then they would try to increase shareholders¿ wealth. To solve this problem first the dynamics of mergers were analysed and then new strategies developed and demonstrated to transfer the financial synergies to the shareholders

Sovereign debt guarantees and default: Lessons from the UK and Ireland, 1920-1938

This research is part of a wider project,“A messy divorce? Irish debt and default, 1891-1938”, conducted by McLaughlin as a Leverhulme Early Career Fellow.We study the daily yields on Irish land bonds listed on the Dublin Stock Exchange during the years 1920–1938. We exploit Irish events during the period and structural differences in land bonds to tease out a measure of investors' credibility in a UK sovereign guarantee. Using Ireland's default on intergovernmental payments in 1932, we find a premium of about 43 basis points associated with uncertainty about the UK government guarantee. We discuss the economic and political forces behind the Irish and UK governments' decisions pertaining to the default. Our finding has implications for modern-day proposals to issue jointly-guaranteed sovereign debt. ‘Further, in view of all the historical circumstances, it is not equitable that the Irish people should be obliged to pay away these moneys’ - Eamon De Valera, 12 October 1932PostprintPeer reviewe