{"id":9910,"date":"2010-02-28T21:50:21","date_gmt":"2010-03-01T01:50:21","guid":{"rendered":"http:\/\/www.prefblog.com\/?p=9910"},"modified":"2010-02-28T21:50:21","modified_gmt":"2010-03-01T01:50:21","slug":"payoff-structure-of-contingent-capital-with-trigger-conversion","status":"publish","type":"post","link":"https:\/\/prefblog.com\/?p=9910","title":{"rendered":"Payoff Structure of Contingent Capital with Trigger = Conversion"},"content":{"rendered":"

As Assiduous Readers will know, I advocate that contingent capital be issued by banks with the conversion trigger being the decline of the common stock below a certain price<\/a>; should conversion be triggered, the conversion into equity of the preferreds \/ Innovative Tier 1 Capital \/ Sub Debt should be at that same price.<\/p>\n

The Conversion\/Trigger price should be set at issue-time of the instrument and, I suggest, be one-half the issue-time price of the common in the case of Tier 1 Capital, with a factor of one-quarter applied for Tier 2 capital. Note that in such a case, Tier 2 capital will not be “gone concern” capital; it will be available to meet losses on a going-concern basis, but the small probability of the issuer’s common losing three-quarters of its value should make it easier, and cheaper, to sell.<\/p>\n

Anyway, one nuance to this idea is that the conversion feature will be supportive of the preferreds price in times of stress, since the preferred will convert at face value into current market price of common.<\/p>\n

In other words, say the price of both common and preferred has nearly, but not quite, halved, but the situation appears to be stabilizing. In such an event, some investors will buy the preferreds in the hope that conversion will be triggered since they will be paid full face value for the preferred in market value of the common. Therefore, the preferreds will be bid up – at least to some extent – in times of stress.<\/p>\n

Let us say that issues exist such that the conversion\/trigger price is $25, but the price of the preferreds has declined such that the effective conversion price is $20. The payoff diagram in terms of the common stock price then looks like this:<\/p>\n

<\/a>
Click for Big<\/i><\/div>\n

This diagram assumes that the conversion\/strike price is $25, and that the preferreds are trading for 80% of face value.<\/p>\n

Thus, an investor contemplating the purchase of the preferreds at 80% of face value will make $5 per share if the common dips just below the trigger price and stays there; he will only realize a loss if the price of the common goes below 80% of the conversion price. This is in addition to any calculations he might make as to the intrinsic value of the preferred if it doesn’t convert, of course.<\/p>\n

This payoff diagram can be analyzed into component options:<\/p>\n

<\/a>
Click for Big<\/i><\/div>\n

In this diagram, I have offset the payoff diagrams for the options slightly in order that they be more readily distinguished.<\/p>\n

It may be seen that the payoff structure can be replicated with three options:<\/p>\n

    \n
  • Long Call, strike $20\n
  • Short Put, strike $20\n
  • Short Call, strike $25<\/ul>\n

    What’s the point? Well, there isn’t one, really. But I wanted to point out the supportive effect of the conversion feature on the preferreds – even in times of stress! – and show how the payoffs could be replicated or hedged in such a case. Doubtless, more mulling over this dissection will lead to more conclusions being drawn about the relative behaviour of preferred and common prices in such a scenario of extreme stress.<\/p>\n","protected":false},"excerpt":{"rendered":"

    As Assiduous Readers will know, I advocate that contingent capital be issued by banks with the conversion trigger being the decline of the common stock below a certain price; should conversion be triggered, the conversion …<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[32],"tags":[],"class_list":["post-9910","post","type-post","status-publish","format-standard","hentry","category-contingent-capital"],"_links":{"self":[{"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/posts\/9910","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/prefblog.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcomments&post=9910"}],"version-history":[{"count":0,"href":"https:\/\/prefblog.com\/index.php?rest_route=\/wp\/v2\/posts\/9910\/revisions"}],"wp:attachment":[{"href":"https:\/\/prefblog.com\/index.php?rest_route=%2Fwp%2Fv2%2Fmedia&parent=9910"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/prefblog.com\/index.php?rest_route=%2Fwp%2Fv2%2Fcategories&post=9910"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/prefblog.com\/index.php?rest_route=%2Fwp%2Fv2%2Ftags&post=9910"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}