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Strategic Analysis of Risk-Shifting Incentives with Convertible Debt

Author

Listed:
  • Pascal François

    (HEC Montréal and CIRPÉE, Department of Finance, 3000 Cote-Ste-Catherine, H3T 2A7 Montreal, Canada)

  • Georges Hübner

    (HEC Management School — University of Liège, Belgium;
    Maastricht University, The Netherlands;
    Gambit Financial Solutions, Belgium)

  • Nicolas Papageorgiou

    (HEC Montréal and CIRPÉE, Canada)

Abstract

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.

Suggested Citation

  • Pascal François & Georges Hübner & Nicolas Papageorgiou, 2011. "Strategic Analysis of Risk-Shifting Incentives with Convertible Debt," Quarterly Journal of Finance (QJF), World Scientific Publishing Co. Pte. Ltd., vol. 1(02), pages 293-321.
    • Handle: RePEc:wsi:qjfxxx:v:01:y:2011:i:02:n:s2010139211000079
    DOI: 10.1142/S2010139211000079
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    References listed on IDEAS

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    1. Assaf Eisdorfer, 2011. "Why is Convertible Debt Subordinated? An Investment‐Based Agency Theory," The Financial Review, Eastern Finance Association, vol. 46(1), pages 43-65, February.
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