Access the publisher's website Journal of Financial and Quantitative Analysis (forthcoming)
This paper introduces and analyzes a new form of contingent convertible: a Call Option Enhanced Reverse Convertible (COERC). If an issuing bank’s market value of capital breaches a trigger, COERCs convert to many new equity shares that would heavily dilute existing shareholders, except that shareholders have the option to purchase these shares at the bond’s par value. COERCs have low risk: they are almost always fully repaid in cash. Yet, they reduce government bailouts by replenishing a bank’s capital. COERCs’ design also avoids problems with market-based triggers, such as manipulation or panic, while reducing moral hazard and debt overhang.