Pascal François

The Agency Structure of Loan Syndicates

Leaders of loan syndicates often delegate some administrative tasks to banks known as co-agents. One reason is that co-agents are specialized banks that help split the costs of managing the syndicate. Another reason is that co-agents monitor the leader on behalf of syndicate members to mitigate informational asymmetry problems. Large sample tests on the Dealscan database provide support for both arguments. Evidence of repeated contracting between the same banks explains the moderate magnitude of monitoring effects.

A dynamic programming approach to price installment options

Installment options are Bermudan-style options where the holder periodically decides whether to exercise or not and then to keep the option alive or not (by paying the installment). We develop a dynamic programming procedure to price installment options. We study in particular the geometric Brownian motion case and derive some theoretical properties of the IO contract within this framework. We also characterize the range of installments within which the installment option is not redundant with the European contract. Numerical experiments show the method yields monotonically converging prices, and satisfactory trade-offs between accuracy and computational time. Our approach is finally applied to installment warrants, which are actively traded on the Australian Stock Exchange. Numerical investigation shows the various capital dilution effects resulting from different installment warrant designs.

Resolution of financial distress under Chapter 11

We develop a contingent claims model for a firm in financial distress with a formal account for renegotiations under the U.S. bankruptcy procedure (known as Chapter 11). Shareholders and two classes of creditors (senior and junior) alternatively propose a reorganization plan subject to a vote. The bankruptcy judge can intervene in any renegotiation round to impose a plan. The multiple-stage bargaining process is solved in a non-cooperative game-theory setting. The calibrated model yields the liquidation rate, the duration of Chapter 11 and the frequency of deviations from the Absolute Priority Rule, which are consistent with empirical evidence.

Optimal hedging when the underlying asset follows a regime-switching Markov process

We develop a flexible discrete-time hedging methodology that minimizes the expected value of any desired penalty function of the hedging error within a general regime-switching framework. A numerical algorithm based on backward recursion allows for the sequential construction of an optimal hedging strategy. Numerical experiments comparing this and other methodologies show a relative expected penalty reduction ranging between 0.9% and 12.6% with respect to the best benchmark.

Game theoretic analysis of negotiations under bankruptcy

We extend the contingent claims framework for the levered firm in explicitly modelling the resolution of financial distress under formal bankruptcy as a non-cooperative game between claimants under the supervision of the bankruptcy judge. The identity of the class of claimants proposing the first reorganization plan is found to be a key determinant of the time spent under bankruptcy, the likelihood of liquidation and the renegotiated value of claims. Our quantitative results confirm the economic intuition that a bankruptcy design must trade-off the initial priority of claims with the viability of reorganized firms.

Tax loss carry-forwards and optimal leverage

Standard contingent claims models of the levered firm examine capital structure choices with the assumption that full offsets of corporate losses are allowed. However, restrictions on tax loss carry-forwards (TLCF) are the rule rather than the exception. The EBIT model of Goldstein et al. (2001) is extended to measure how optimal leverage is affected by restrictions on TLCF. The restricted TLCF case reconciles the static trade-off model with the evidence that (i) optimal leverage is decreasing with firm growth and (ii) firms benefiting from TLCF may issue debt less aggressively.

Credit Derivatives with Multiple Debt Issues

We extend the class of structural models of credit derivatives by allowing for multiple debt issues. Since firms default on all of their obligations, total debt is instrumental in the likelihood of default and therefore in credit derivatives valuation. We use a mono-factor interest rate model where the exponential default frontier is based on total debt and is made coherent with observed bond prices. Analytical formulae are derived for credit default swaps, total return swaps (both fixed-for-fixed and fixed-for-floating), and credit risk options. Simulations document that credit derivatives prices are affected in a non-trivial way by terms of debt other than those of the reference obligation.

Optimal Hedging when the Underlying Asset Follows a Regime-Switching Markov Process

We develop a flexible discrete-time hedging methodology that minimizes the expected value of any desired penalty function of the hedging error within a general regime-switching framework. A numerical algorithm based on backward recursion allows for the sequential construction of an optimal hedging strategy. Numerical experiments comparing this and other methodologies show a relative expected penalty reduction ranging between 0.9% and 12.6% with respect to the best benchmark.

Strategic Analysis of Risk-Shifting Incentives with Convertible Debt

Convertible debt eliminates asset substitution in a one-period setting (Green, 1984). But convertible debt terms are usually set before the asset substitution opportunity. This allows shareholders and convertible debtholders to play a strategic noncooperative game. Two risk-shifting Nash equilibria are attainable:pure asset substitutionwhen, despite no conversion, shareholders benefit from shifting risk, andstrategic conversionwhen, despite early conversion, convertible debtholders expropriate wealth from straight debtholders. Even when initial convertible debt is designed to minimize the risk-shifting likelihood, the risk of asset substitution remains economically substantial — contrasting with the agency theoretic rationale for issuing convertible debt.

Corporate Debt Valuation: The Structural Approach

This chapter surveys the contingent claims literature on the valuation of corporate debt. Model summaries are presented in a continuous-time arbitrage-free economy. After a review of the basic model, I extend the approach to models with an endogenous capital structure, discrete coupon payments, flow-based state variables, interest rate risk, strategic debt service, and more advanced default rules. Finally, I assess the empirical performance of structural models in light of the latest tests available.