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
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: Suggested Citation
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