Marcin Liberadzki

Principles of the toll roads pricing

In this paper the authors refer to the method of commercial provision of road infrastructure called BOT (build-operatetransfer) under Public-private partnerships (PPPs) scheme. First we present the investment criteria for transportation PPP projects as well as application of price theory. Then we recognize that the different participants in PPP projects have distinct goals and requirements that must be met in order for them to be able to participate in an effective partnership. The main challenge for the toll road pricing is to determine the economically viable toll rate that takes into consideration the diverse and sometimes conflicting interests of different stakeholders involved in the project. The main objective is to review the theory of economic principles for optimal toll roads pricing and to review the existing approaches to transportation projects appraisal. Then the authors show how to formally derive the condition for toll rate that meets 2 criteria: 1) is socially optimal and 2) covers operator’s costs. For this purpose we use II type Tőrnquist function, a member of an Engel family of functions. This function models the relationship between income and consumption of inferior and normal goods. Tőrnquist function is a mathematical representation of the well-known Engel curves. These curves record the relationship between the quantity of goods purchased and total income. They are not necessarily straight lines. The demand for some “luxury” goods may increase proportionally more rapidly than income, whereas the demand for “necessities” may grow proportionally less rapidly than income. The precise shape will depend on the individual’s preferences for goods as reflected in the indifference curve map. We deem the highway trip to be a “second necessity good”. There is number of economists who apply the Tőrnquist function for microeconomic analysis. The extremely simple form of the Tőrnquist function allows to get the solution in a closed form.

Hybrid Securities Issued by Insurers

Under the Solvency II Directive,1 EU insurers are required to maintain a specific level of capital which is categorized into levels or ‘tiers’: so-called high quality capital (T1), good quality capital (T2) and finally Tier 3 (T3), which can be described as low quality capital. The concept of tiers is similar to the CRD IV/CRR. Both the CRD IV/CRR and Solvency II classify financial instruments into specified tiers based on the valuation of their pre-bankruptcy and post-bankruptcy loss-absorption features. Loss absorption on a going-concern basis is achieved primarily through dividend cancellation in the absence of profit and profit reserves. The same effect brings about non-cumulative coupon deferral in the case of hybrid securities. Another loss-absorbing feature is the conversion of hybrids into common equity or a partial, if not full, write-down of their principal value. In case of insolvency, senior bonds rank before subordinated bonds. Common equity, in turn, has the lowest recovery rate.

CRD IV Package Legal Framework

Under the CRD IV regulatory package, EU banks have to fulfill certain capital requirements, which are grouped inter alia as Tier 1 and Tier 2 financial instruments. Tier 1 instruments constitute the ‘going-concern capital’ of the financial institution, while Tier 2 instruments form the ‘gone-concern capital’. This means that Tier 1 instruments may absorb losses of the institution on an ongoing basis, while Tier 2 instruments absorb losses when a financial institution becomes insolvent or faces liquidation. The core of this system is an instrument known as the Common Equity Tier 1 (CET1). A CET1 must be composed of the highest quality of capital and possess maximum loss-absorption capacity. CET1 instruments are mainly common shares and retained earnings, while hybrid bonds may be assigned to either the category of Additional Tier 1 (AT1) or that of Tier 2 (T2), provided that certain criteria are met. These criteria also may be classified in a manner reflecting the aforementioned dimensions of the debt–equity continuum (Figure 4.1).

Structural Model for Corporate Hybrid Valuation

The structural approach enables pricing subordinated tranches of debt and therefore will be applied in this chapter. The model presented here was specified by Jaworski, Liberadzki and Liberadzki (2015b).

Regular and Timely Ongoing Disclosure

The previous chapter demonstrated how the information provided under the Prospectus Directive is used to determine the risk connected with offered securities and, consequently, their price. Only if investors possess such information will they be able to make a decision on the purchase of securities. Once investors purchase a financial hybrid, the issuer raises regulatory capital. With that, the role of the primary market in the process of raising capital is done. Some investors may be willing to keep the debt securities on their accounts until the securities mature (or, in case of perpetual hybrids, until the first call date), collecting coupon payments and waiting for the principal to be repaid (called). However, it would be impossible to raise capital without granting investors the ability to sell their securities. The existence of the secondary market is necessary for the effective operation of the primary market. That is especially true when discussing the equity market, because debt securities are traditionally considered more of a buy and hold investment, so the debt market is less liquid than the equity market. In the case of financial hybrids, recent RBS surveys demonstrate that the liquidity of the instrument is also taken into account by investors. However, we need to note that CoCo investors pay relatively little attention to past volatility of liquidity. Instead, they tend to focus on (i) the fundamentals of the issuing financial institution, (ii) the distance from the trigger point and (iii) the risk of coupon deferral and type of conversion (RBS, May 2014).

Definition and Framework for Contagion and Divergence Effect Modeling

The paper examines contagion effect and divergence effect referring to sovereign bond yields. Both effects should be understood as an increase in interdependency among different class of assets as a result of a significant shock. Contagion refers to positive interdependency, while the negative correlation illustrates divergence effect.The contagion/divergence effect is being somehow overlooked by classic risk models, as they base on constant volatility, mean and correlation assumption. The contagion process may be translated into three effects: spillover, transmission and comovement. All these creates a challenge for contagion risk modeling, as different class of models, including both static and dynamic features, must be contemplated. The paper organizes the methodology and presents main concepts for contagion effect modeling within both spatial and time approach. As the same index is utilized for contagion as well as divergence modeling, it is possible to analyses and compare this opposite effects together referring to selected sovereign bond market data.

The Role of Hybrid Securities in the BRRD

The BRRD is a cornerstone of the single European bank resolution mechanism. Such a mechanism is urgently needed, as financial institutions conduct their business on a cross-border or even a pan-European basis, while legislation of member states differs significantly on insolvency issues. Financial markets are highly integrated beyond national borders, so the failure of a financial institution will also have cross-border consequences. Therefore, the lack of harmonization in the feld of bank resolution threatens the stability of financial markets – a condition that has been identified as essential for both the establishment and functioning of the internal market (BRRD Recital 4). The BRRD regime equips regulators or resolution authorities with tools, powers and measures that enable them to act both on going-concern and gone-concern bases. It is explicitly mentioned that governmental financial stabilization tools, including temporary public ownership, may be going-concern tools of last resort (BRRD Recital 8). It is also strongly emphasized that the use of tools and powers provided under the BRRD regime may affect the property rights of shareholders and jeopardize equal treatment of creditors. However, it must also be stressed that any difference in the treatment of creditors of the same class can be justified when such different treatment is carried out in the public interest, in a proportionate and non-discriminatory manner (BRRD Recital 13).

Legal Framework for Financial Hybrids in the Banking Industry

Prudent capital requirements are set out in the CRD IV package – the fourth Capital Requirements Directive and Capital Requirements Regulation. These requirements are based on internationally accepted principles of Basel III. They preserve the level playing feld inside the Single Market by achieving a Single Rule Book for all banks in the EU. Financial hybrids play an important role in the tier-based capital structure imposed by the CRD IV package, which will be examined in detail below.

Evolution of Hybrids

Preferred shares carry no voting rights. Instead, they offer regular income (on a fixed basis) and have priority over common equity in dividend payments. These characteristics are clearly mirrored by ‘preferreds’ in French law (actions a dividende prioritaire sans droit de vote) and German law (Vorzugaktien). Not all jurisdictions require all preferred shares to be stripped from voting rights, but this is the most common structure. Preferred shares in the United States are more similar to fixed income instruments, while preferred shares in continental Europe pay less attention to regularity of income. Such instruments are designed to give the investors extended share in annual company earnings (i.e. up to 150% of dividends on common stock).

Public Offering and Admission to Trading

Obtaining information about the goods the one is about to acquire is necessary for each buyer to make a reasonable decision on the offer and its price. This applies also to all securities, including – of course – hybrids. Investors will require a written presentation on the terms of the security, the business and prospects of its issuer, and any risks attached to the security. In case of the latest generation of financial hybrid instruments being discussed, proper description of the risk attached to the security will be of key importance.