Pricing Contingent Convertible Bond with Idiosyncratic Risk

Wang, X., Yang, Z. & Zeng, P. (2023) Pricing contingent convertibles with idiosyncratic risk. International Journal of Economic Theory, 1–34. https://doi.org/10.1111/ijet.12372

44 Pages Posted: 16 Dec 2012 Last revised: 3 Mar 2023

See all articles by Xiaolin Wang

Xiaolin Wang

Hunan University

Zhaojun Yang

Southern University of Science and Technology - Department of Finance

Pingping Zeng

Southern University of Science and Technology

Date Written: February 19, 2023

Abstract

We consider capital structure including equity, straight bonds (SBs), and contingent convertibles (CoCos) for non-financial firms. We price equity and CoCos by a utility-based method. We show that benefits from issuing CoCos increase dramatically with idiosyncratic risk and risk aversion. The firm value is concave in CoCos' conversion ratio and the optimal conversion ratio increases with risk aversion and idiosyncratic risk. If risk aversion is sufficiently high, shareholders' risk-shifting incentives disappear, and the firm issues less CoCos and equity and more SBs as idiosyncratic risk rises. The higher the idiosyncratic risk or risk aversion, the higher the leverage.

Keywords: contingent convertible bond, capital structure, utility-based pricing, idiosyncratic risk, risk-taking incentive

JEL Classification: G21, G28, G32, G33

Suggested Citation

Wang, Xiaolin and Yang, Zhaojun and Zeng, Pingping, Pricing Contingent Convertible Bond with Idiosyncratic Risk (February 19, 2023). Wang, X., Yang, Z. & Zeng, P. (2023) Pricing contingent convertibles with idiosyncratic risk. International Journal of Economic Theory, 1–34. https://doi.org/10.1111/ijet.12372, Available at SSRN: https://ssrn.com/abstract=2190023 or http://dx.doi.org/10.2139/ssrn.2190023

Xiaolin Wang

Hunan University ( email )

School of Finance and Statistics
Changsha, CA 410079
China

Zhaojun Yang (Contact Author)

Southern University of Science and Technology - Department of Finance ( email )

Pingping Zeng

Southern University of Science and Technology ( email )

1088 Xueyuan Avenue
Nanshan District
Shenzhen, Guangdong
China

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