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Investigating the effectiveness of convertible bonds in reducing agency costs: A Monte-Carlo approach

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  • Siddiqi, Mazhar A.
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    Abstract

    Simulation and option pricing techniques are used to value the marginal effect of asset risk on stock value. I find the optimal mix of stock, debt and convertible bonds that reduces this marginal effect to zero. At this optimal point the agency costs of debt are minimized. The incentive to add risky projects that arises from ordinary debt is offset by the incentive to ignore risky projects that arises from convertible debt.

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    File URL: http://www.sciencedirect.com/science/article/B6W5X-4X60TF4-2/2/55e489126229fd2dfdd809e65bd67e05
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    Bibliographic Info

    Article provided by Elsevier in its journal The Quarterly Review of Economics and Finance.

    Volume (Year): 49 (2009)
    Issue (Month): 4 (November)
    Pages: 1360-1370

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    Handle: RePEc:eee:quaeco:v:49:y:2009:i:4:p:1360-1370

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    Web page: http://www.elsevier.com/locate/inca/620167

    Related research

    Keywords: Agency costs Convertible bonds Capital structure Real options Simulations;

    References

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    1. Craig M. Lewis & Richard J. Rogalski & James K. Seward, 1999. "Is Convertible Debt a Substitute for Straight Debt or for Common Equity?," Financial Management, Financial Management Association, vol. 28(3), Fall.
    2. Gavish, Bezalel & Kalay, Avner, 1983. "On the Asset Substitution Problem," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 18(01), pages 21-30, March.
    3. Jeremy C. Stein, 1992. "Convertible Bonds as "Back Door" Equity Financing," NBER Working Papers 4028, National Bureau of Economic Research, Inc.
    4. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
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    6. Barnea, Amir & Haugen, Robert A & Senbet, Lemma W, 1980. " A Rationale for Debt Maturity Structure and Call Provisions in the Agency Theoretic Framework," Journal of Finance, American Finance Association, vol. 35(5), pages 1223-34, December.
    7. Mark Broadie & Paul Glasserman, 1996. "Estimating Security Price Derivatives Using Simulation," Management Science, INFORMS, vol. 42(2), pages 269-285, February.
    8. Ingersoll, Jonathan E, Jr, 1977. "An Examination of Corporate Call Policies on Convertible Securities," Journal of Finance, American Finance Association, vol. 32(2), pages 463-78, May.
    9. Brennan, Michael J. & Schwartz, Eduardo S., 1980. "Analyzing Convertible Bonds," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(04), pages 907-929, November.
    10. Manuel Ammann & Axel Kind & Christian Wilde, 2005. "Simulation-Based Pricing of Convertible Bonds," Finance 0507015, EconWPA.
    11. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    12. Smith, Clifford Jr. & Warner, Jerold B., 1979. "On financial contracting : An analysis of bond covenants," Journal of Financial Economics, Elsevier, vol. 7(2), pages 117-161, June.
    13. Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, vol. 13(2), pages 187-221, June.
    14. Brennan, M J & Schwartz, Eduardo S, 1977. "Convertible Bonds: Valuation and Optimal Strategies for Call and Conversion," Journal of Finance, American Finance Association, vol. 32(5), pages 1699-1715, December.
    15. Stewart C. Myers & Nicholas S. Majluf, 1984. "Corporate Financing and Investment Decisions When Firms Have InformationThat Investors Do Not Have," NBER Working Papers 1396, National Bureau of Economic Research, Inc.
    16. Brennan, Michael J. & Schwartz, Eduardo S., 1977. "Savings bonds, retractable bonds and callable bonds," Journal of Financial Economics, Elsevier, vol. 5(1), pages 67-88, August.
    17. Mello, Antonio S & Parsons, John E, 1992. " Measuring the Agency Cost of Debt," Journal of Finance, American Finance Association, vol. 47(5), pages 1887-904, December.
    18. Barone-Adesi, Giovanni & Bermudez, Ana & Hatgioannides, John, 2003. "Two-factor convertible bonds valuation using the method of characteristics/finite elements," Journal of Economic Dynamics and Control, Elsevier, vol. 27(10), pages 1801-1831, August.
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    Cited by:
    1. Zeidler, Felix & Mietzner, Mark & Schiereck, Dirk, 2012. "Risk dynamics surrounding the issuance of convertible bonds," Journal of Corporate Finance, Elsevier, vol. 18(2), pages 273-290.
    2. Christian Dorion & Pascal François & Gunnar Grass & Alexandre Jeanneret, 2014. "Convertible Debt and Shareholder Incentives," Cahiers de recherche 1403, CIRPEE.
    3. Dorion, Christian & François, Pascal & Grass, Gunnar & Jeanneret, Alexandre, 2014. "Convertible debt and shareholder incentives," Journal of Corporate Finance, Elsevier, vol. 24(C), pages 38-56.

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