Contingent Capital, Tail Risk, and Debt-Induced Collapse

Nan Chen; Paul Glasserman; Behzad Nouri; Markus Pelger

doi:10.1093/rfs/hhx067

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Contingent Capital, Tail Risk, and Debt-Induced Collapse

Nan Chen¹; Paul Glasserman²; Behzad Nouri²; Markus Pelger³

¹ Chinese University of Hong Kong · ² Columbia University · ³ Stanford University

Review of Financial Studies 2017

We study the design and incentive effects of contingent convertible debt. With contingent convertibles, the endogenous bankruptcy boundary can be at either of two levels: one with lower default risk or one at which default precedes conversion. An increase in debt moves the firm from the first regime to the second, a phenomenon we call debt-induced collapse. Setting the conversion trigger sufficiently high avoids this hazard. Given this condition, we investigate the effect of contingent capital and debt maturity on optimal capital structure, debt overhang, and asset substitution. We calibrate the model to large banks during the financial crisis. Received April 10, 2015; editorial decision March 20, 2017 by Editor Leonid Kogan.

DOI: 10.1093/rfs/hhx067
Volume: 30 (11)
Pages: 3921-3969
Language: en
Export: BibTeX
Sources: openalex crossref