Conic coconuts: the pricing of contingent capital notes using conic finance

Abstract

In this paper we introduce a fundamental model under which we will price contingent capital notes using conic finance techniques. The model is based on more realistic balance-sheet models recognizing the fact that asset and liabilities are both risky and have to be treated differently taking into account bid and ask prices in a prudent fashion. The underlying theory makes use of conic finance which is based on the concept of acceptability and distorted expectations. We recall the theory and give a brief overview of the related literature. Next, we discuss and propose some potential funded and unfunded contingent capital notes. Traditionally, the conversion trigger of contingent capital notes is in terms of the Core-Tier 1 ratio. We argue that this ratio is maybe not optimal, certainly when taking into account the presence of risky liabilities. As an alternative we introduce triggers based on capital shortfall. The pricing of seven variations of funded as well as unfunded notes is overviewed. We further investigate the effect of the dilution factor and the grace factor. In an appendix we show conic balance sheets including contingent capital instruments.