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Pricing Under Endogenous Capital Structure Changes and Discontinuous Trading

The knowledge of the type of cash-flows offered by an asset, such as either equity-like or debt-like, is necessary for its net present valuation. Recently, the consequences of trades of assets with ambiguous cash-flows on financial systems have been discussed. Several forms of contingent capital proposed as automatic recapitalization tools for large banks are assets of this type, since the type of cash-flows they provide are not in a unidirectional causal relationship with the capital structure of their issuer. We study the net present valuation of assets of this kind that accounts for the investors' wealth factors, and give sufficient and necessary conditions under discontinuous trading for its existence and uniqueness. We illustrate the pricing method for a firm's debt that is automatically modified when the firm's equity trading price declines to a predetermined level. Depending on its contract characteristics, this debt is either converted into new equity, written-down or written-off. We consider distinct cases with capital structure change favoring either equity or debt holders.