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Risk Shifting, Conversion Rules, and Optional Payment Schedules

35 Pages Posted: 26 Jul 2010 Last revised: 15 Aug 2010

Simone M. Sepe

University of Arizona - James E. Rogers College of Law; IAST - Fondation Jean-Jacques Laffont - TSE ; University of Toulouse 1 - Industrial Economic Institute (IDEI)

Date Written: August 13, 2010

Abstract

Prior theories of convertible debt have showed that this instrument can mitigate the risk-shifting problem arising when managers substitute risky projects for safer ones, since the attribution to debt investors of a contingent equity claim can deconvexify the shape of levered equity. However, existing risk-shifting theories of convertibles omit to fully consider that these instruments must be designed so to leave investors a large part of project rents – to specify high conversion ratios – to provide effective deterrence against risk-shifting incentives.

My first contribution to the literature on convertible debt and risk shifting is to show that, given a specific cash flow distribution, it is possible to design conversion features so to create an upward jump discontinuity in investors’ payoff function. By making the firm's payment schedule non-monotonic, this jump discontinuity implicitly raises the leverage of the conversion option, without, however, increasing the project rents investors can capture. My second contribution is to show that when the level of fixed claims is exogenously, rather than endogenously determined, the optimal convertible debt contract is implemented by granting debt investors two options. At an interim date, investors can choose one between two alternative conversion plans: a debt-like and an equity-like conversion plan. Once payoff are realized, investors can then choose whether to convert or not. Finally, policy considerations are extensively discussed.

Keywords: Asset Substitution, Convertible Debt, Corporate Governance, Risk Shifting, SOSD

JEL Classification: G3, K22

Suggested Citation

Sepe, Simone M., Risk Shifting, Conversion Rules, and Optional Payment Schedules (August 13, 2010). Arizona Legal Studies Discussion Paper No. 10-30. Available at SSRN: https://ssrn.com/abstract=1649148

Simone M. Sepe (Contact Author)

University of Arizona - James E. Rogers College of Law ( email )

P.O. Box 210176
Tucson, AZ 85721-0176
United States

IAST - Fondation Jean-Jacques Laffont - TSE ( email )

21 allée de Brienne
31015 Toulouse Cedex 6
Toulouse Cedex, F-31042
France

University of Toulouse 1 - Industrial Economic Institute (IDEI) ( email )

Manufacture des Tabacs
21 Allee de Brienne bat. F
Toulouse Cedex, F-31000
France

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