Convertible Debt Under Asymmetric Information and Agency Problems: A Solution to the Convertible Debt Puzzle

46 Pages Posted: 16 Mar 2006

See all articles by Fernando R. Diaz

Fernando R. Diaz

School of Business and Economics, Universidad Diego Portales

Rodolfo Martell

Barclays Global Investors; Purdue University - Krannert School of Management

Gabriel G. Ramirez

Kennesaw State University - Michael J. Coles College of Business

Date Written: March 2006

Abstract

We develop a model with asymmetric information and agency problems that is able to explain simultaneously three empirical regularities associated with the issuance and conversion of convertible bonds. First, the model predicts that the negative stock price reactions observed when convertible bonds are issued are related to agency conflicts between firm management and stockholders, and to the type of firm that is issuing convertible debt. Second, the negative returns observed when bonds are subsequently called are explained in an equilibrium in which only bad managers call their in-the-money convertibles in low value states of nature. Third, the model explains the less negative returns seen at the redemption announcement day (compared to those observed at the issuance announcement day). We also provide empirical evidence in support of the model propositions. In short, we find that firms with a higher probability of agency conflicts exhibit significantly more negative stock price reactions at the offering announcement day and are more likely to force conversion of their in-the-money convertible bonds. Finally, we also find that firms that call out-of-the-money convertibles do not experience negative returns at the redemption announcement day.

Keywords: convertible debt, callable debt, forced conversion, converitble debt puzzle, asymetric information, agency problems

JEL Classification: G32

Suggested Citation

Diaz, Fernando R. and Martell, Rodolfo and Ramirez, Gabriel G., Convertible Debt Under Asymmetric Information and Agency Problems: A Solution to the Convertible Debt Puzzle (March 2006). Available at SSRN: https://ssrn.com/abstract=891174 or http://dx.doi.org/10.2139/ssrn.891174

Fernando R. Diaz (Contact Author)

School of Business and Economics, Universidad Diego Portales ( email )

Av. Manuel Rodriguez 253
Santiago
Santiago, RM 8370057
Chile
(56 2) 6762804 (Phone)

HOME PAGE: http://www.udp.cl/academicos/directorio_profesores_detalle.asp?iId=1463

Rodolfo Martell

Barclays Global Investors ( email )

45 Fremont Street
San Francisco, CA 94105
United States

Purdue University - Krannert School of Management ( email )

403 West State Street
KRAN 477
West Lafayette, IN 47907-2056
United States

Gabriel G. Ramirez

Kennesaw State University - Michael J. Coles College of Business ( email )

1000 Chastain Road
Kennesaw, GA 30144
United States
770-423-6181 (Phone)

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