Contingent Convertible Bonds and the Optimal Default Barrier

Abstract

This thesis provides a comprehensive overview of the sensitivity of the optimal default barrier in regard to its input parameters and the use of contingent convertible bonds. Contingent convertible bonds are financial instruments designed to help banks prevent default and absorb losses by converting from debt to equity in times of financial distress. We also study how contingent convertible bonds would have affected the optimal default barriers of the four biggest Swedish banks during the 2007-2009 financial crisis. The results from this thesis suggest that issuing contingent convertible bonds typically increase the optimal default barrier, but that the negative impact on solvency is diminished during the financial crisis. We conclude that the usefulness of contingent convertible bonds is primarily derived from its utility as a bail-in instrument, rather than as a tool to prevent default.