Grants and Contributions:

Grant or Award spanning more than one fiscal year. (2017-2018 to 2022-2023)

This research plan centres on two sets of linked and complementary quantitative finance research programs: 1) simulation, optimal control, and numerical methods in finance; and 2) studies in contingent capital securities. The first project focusses on efficient methods for pricing and risk management of derivative securities with early exercise features. These techniques are important to financial institutions and investors for trading and internal risk management processes and also for determining required capital levels to satisfy both internal and external (regulatory) demands. Monte Carlo methods will be extensively studied, along with some other numerical methods suited for such problems. Results from this work have broader applications such as financial portfolio management, the operation of power generating stations, and the optimal scheduling of maintenance in large systems such as a series of reservoirs.

Since the 2008 financial crisis there has been renewed interest by governments and regulators to find ways to avoid taxpayer-funded bailouts of financial institutions (FIs), with contingent capital (CoCo) garnering much of this interest. CoCos are instruments that are debt (or preferred shares) when issued and that convert to common equity when the issuing FI is in financial distress. Conversion has the effect of re-capitalizing the FI exactly when it would be most difficult for them to raise funds in capital markets through the issuance of new securities. Additionally, conversion dilutes the ownership stake of the pre-conversion shareholders and may potentially curb excessive risk taking in the financial industry as losses will be imposed on the firm’s investors, rather than taxpayers. There is no standard set of terms for CoCos and the properties of CoCos vary depending on the conditions that trigger conversion and the number of common shares that CoCo holders receive upon conversion (e.g., the conversion price).

Results from this proposal will deepen our understanding of the properties of CoCos, allow regulators the proper tools to assess various CoCo designs, and provide issuers and investors more clarity on CoCo value. Additionally, the research will explore related pricing and risk-management issues associated with CoCos, such as how an issuer can manage interest-rate risk on CoCo liabilities, with the possibility of conversion changing this liability to non-interest-paying equity. A thorough understanding of CoCos, including design specifications, pricing and hedging models, and the associated financial and risk objectives will have important societal benefits. Well-designed CoCos will strengthen both individual FIs and, as a result, the financial system, making taxpayer-funded bailouts less likely. Furthermore, this understanding will help facilitate issuance and secondary market trading, potentially lowering the cost of capital.