This paper investigates the e¤ects of …nancial institutions issuing contingent capital, a debt security that automatically converts into equity if assets fall below a predetermined threshold. We analyze a tractable form of contingent convertible bonds ("coco") and provide a closed-form solution for the price. We quantify the reduction in default probability associated with contingent capital as compared to subordinated debt. We then show that appropriate choice of contingent capital parameters (conversion ratio and threshold) can virtually eliminate stockholders'incentives to risk-shift, a motivation that is present when bank liabilities instead include either only equity or subordinated debt. Importantly, risk-taking incentives continue to be weak during times of …nancial distress. Our …ndings imply that contingent capital may be an e¤ective tool for stabilizing …nancial institutions.JEL Classi…cation: G13, G21, G28, E58
While it is well understood theoretically that higher inflation will lower the real value of outstanding government debt, empirically there is neither a method nor plausible estimates of how large this effect will be. We propose a method that takes an ex ante perspective of the government budget constraint, and relies on having detailed information on debt held by the public at different maturities, risk-neutral densities for future inflation at different horizons, and a set of plausible counterfactuals. Applying it to the United States in 2012, we estimate that the effects of higher inflation on the fiscal burden are modest. A more promising route to inflate away the public debt is to use financial repression, and we estimate that a decade of repression combined with inflation could wipe out almost half of the debt.JEL codes: E31, E42, E58
This paper proposes a new method for measuring the impact of inflation on the real value of public debt. The distribution of debt debasement is based on two inputs: the distribution of privately held nominal debt by maturity, for which we provide new estimates, and the distribution of risk-adjusted inflation dynamics, for which we provide a novel copula estimator using options data. We find that inflation by itself is unlikely to lower the U.S. fiscal burden significantly because debt is concentrated at short maturities and perceived inflation shocks have little short-run persistence and are small.
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