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Dynamic Hedging Incentives, Debt, and Warrants

34 Pages Posted: 3 Aug 2004  

Chris Hennessy

London Business School

Yuri Tserlukevich

Arizona State University (ASU)

Date Written: January 14, 2004

Abstract

In a static setting, Green (1984) shows that a warrant contract can eliminate the asset substitution problem created by debt. In contrast, we show that when the firm chooses volatility dynamically, no warrant can eliminate asset substitution, as equity is always risk-loving when the firm is near default. The hedging incentive produced by a warrant is weakest when the option is out of the money, precisely when the speculative incentive due to limited liability is strongest. Although warrants mitigate dynamic asset substitution, we show that they exacerbate the agency problem of premature default (underinvestment). Indeed, unless a firm has sufficient volatility discretion, the costs of premature default dominate. For firms with sufficient volatility discretion, where warrants potentially increase value, they do so only if they grant large equity stakes. The optimal warrant contract entails "maximum deterrence," fully diluting existing shareholders upon conversion.

Keywords: Capital Structure, Debt, Warrant, Asset Substitution

JEL Classification: G32, G13

Suggested Citation

Hennessy, Chris and Tserlukevich, Yuri, Dynamic Hedging Incentives, Debt, and Warrants (January 14, 2004). EFA 2004 Maastricht Meetings Paper No. 5094. Available at SSRN: https://ssrn.com/abstract=559409 or http://dx.doi.org/10.2139/ssrn.559409

Christopher Hennessy

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Yuri Tserlukevich (Contact Author)

Arizona State University (ASU) ( email )

Farmer Building 440G PO Box 872011
Tempe, AZ 85287
United States

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