The design and pricing of hybrid debt

Excessive risk taking and low capital buffers are considered to be important causes of the 2008 financial crisis. Hybrid debt such as contingent convertible bonds (CoCos) can potentially mitigate these problems. However, the scientific literature shows that CoCos with a market trigger do not necessarily have a unique competitive equilibrium price. Furthermore, there is no consensus on whether CoCos are effective at mitigating risk-taking incentives.

This thesis firstly introduces a CoCo with a market trigger and floating coupons. This CoCo does have a unique competitive equilibrium price. Secondly, a new pricing model is introduced for CoCos with a market trigger. By distinguishing between investors based on differences in market power and allowing investors to affect prices, this model yields a unique equilibrium price. This model also resolves the pricing problem for equities of firms in a market based index and equities of firms where decision making is based on the equity price. Thirdly, a new debt contract is introduced: Risk incentive compatible bonds (RIC-bonds). These RIC bonds are a debt contract with both fixed and floating coupons. The floating coupons are nonzero when the assets of the RIC-bond issuing firm provide high cash-flows. This makes it no longer attractive for the firm to increase risk taking. Issuing RIC-bonds can consequently lead to lower capital costs, as it is a credible signal that the firm will limit risk taking. This makes RIC-bonds an attractive debt instrument for firms and suitable to mitigate excessive risk-taking incentives.