Abstract: In response to the Great Recession, contingent convertible bonds have been pitched as the only debt instrument providing fully loss-absorbing going-concern capital to financial institutions. Legitimized by Basel III, they have rapidly become the hallmark of fi nancial stability. Detractors have however raised concerning points about hedging and price stability, including the so-called death spiral, which is a self-fulfi lling collapse in the underlying stock price as a result of delta hedging. Those points call into question the validity of this new security as a stabilizing force to the financial system. Seeking to address those concerns, this research begins with a thorough review of the literature on the current market environment, the structure and design of contingent convertible bonds and the various methods developed to price this hybrid security. It then expands the scope of the current literature, proceeding with an analysis of the hedging dynamics, the introduction of credit default swaps, and the sensitivity of the price to shifts in market opinions. Overall, this research finds that while signi ficant, the risks and repercussions of a death spiral have been overblown. The strong emphasis on this particular issue in the press overshadows many of their other concerning features, including the distorted market-clearing price that currently prevails, the counterparty risk that could arise from the creation of a market for credit default swaps, and their high sensitivity to subjective market opinions.
Year
Recipient
Frederic Tremblay