Concept[ edit ] The concept was proposed by Professor Robert Merton in as a guarantee that gives holders "contractual right to seize the firm's assets or its equity interest whenever the value of assets is below the value of its guaranteed debt.
The trigger and the conversion rate[ edit ] A contingent convertible bond is defined with two elements: the opțiune convertibilă and the conversion rate.
While the trigger is the pre-specified event causing the conversion process, the conversion rate is the actual rate at which debt is swapped for equity. Hence, as compared to common equity, the cost of capital and, consequently, the cost of maintaining a risk absorbing facility are lower.
In case the trigger event occurs, conversion of debt into equity drives down company's leverage. When the trigger is well chosen, automatic conversion reduces leverages precisely when the bank faces high incentives for risk shifting.
Accordingly, this feature ensures a preventive effect on endogenous risk creation, unlike any other form of bank debt. Some argue that conversion could produce negative signaling effects leading to potential financial contagion and price manipulation.