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Informative Conversion Ratios: A Signalling Approach

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  • Kim, Yong O.

Abstract

The paper uses a signalling equilibrium to explain the market's reaction to the announcement of a firm's financing decision. In our model, a firm can issue one of the following securities: convertible debt with a different conversion ratio, straight debt, and stock. We identify conditions under which the conversion ratio of a convertible debt issue serves as a credible signal of a firm's private information, given the continuous distribution of attributes (information) across firms. In this signalling equilibrium, we find that the lower the expected future earnings, the higher the conversion ratio of a convertible debt issue. At the limit, firms that expect the highest earnings will use straight debt financing, and firms that expect the lowest earnings will use equity financing. Based on the signalling equilibrium, we predict that at announcement of a convertible debt issue, negative abnormal common stock return increases in absolute value with the conversion ratio.

Suggested Citation

  • Kim, Yong O., 1990. "Informative Conversion Ratios: A Signalling Approach," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 25(2), pages 229-243, June.
    • Handle: RePEc:cup:jfinqa:v:25:y:1990:i:02:p:229-243_00
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    Cited by:

    1. Kim, Yong O. & Kallberg, Jarl, 1998. "Convertible calls and corporate taxes under asymmetric information," Journal of Banking & Finance, Elsevier, vol. 22(1), pages 19-40, January.
    2. Burlacu, Radu & Jimenez-Garcès, Sonia, 2022. "Why do firms issue callable convertible bonds? A critique of the “backdoor equity financing” theory," Journal of Banking & Finance, Elsevier, vol. 144(C).
    3. Loncarski, I. & Ter Horst, J.R. & Veld, C.H., 2006. "Why do Companies issue Convertible Bond Loans? An Empirical Analysis for the Canadian Market," Discussion Paper 2006-65, Tilburg University, Center for Economic Research.
    4. Marszałek Jakub, 2015. "The Essence Of The Emerging Markets’ Investment Risk. Comparative Analysis Of American And Central European Convertible Bond Issuers / Istota Ryzyka Inwestycyjnego Rynków Wschodzących. Analiza Porówna," Comparative Economic Research, Sciendo, vol. 18(3), pages 81-97, August.
    5. Magennis, Darren & Watts, Edward & Wright, Sue, 1998. "Convertible notes: the debt versus equity classification problem," Journal of Multinational Financial Management, Elsevier, vol. 8(2-3), pages 303-315, September.
    6. Dutordoir, Marie & Lewis, Craig & Seward, James & Veld, Chris, 2014. "What we do and do not know about convertible bond financing," Journal of Corporate Finance, Elsevier, vol. 24(C), pages 3-20.
    7. Burlacu, Radu, 2000. "New evidence on the pecking order hypothesis: the case of French convertible bonds," Journal of Multinational Financial Management, Elsevier, vol. 10(3-4), pages 439-459, December.
    8. Ammann, Manuel & Fehr, Martin & Seiz, Ralf, 2006. "New evidence on the announcement effect of convertible and exchangeable bonds," Journal of Multinational Financial Management, Elsevier, vol. 16(1), pages 43-63, February.
    9. Suchard, Jo-Ann, 2007. "The impact of rights issues of convertible debt in Australian markets," Journal of Multinational Financial Management, Elsevier, vol. 17(3), pages 187-202, July.
    10. Fitriya Fauzi & Dani Foo & Abdul Basyith, 2017. "Islamic Bond Announcement: Is There Any Effect on Returns?," Global Business Review, International Management Institute, vol. 18(2), pages 327-347, April.
    11. Jung, Mookwon & Sullivan, Michael J., 2009. "The signaling effects associated with convertible debt design," Journal of Business Research, Elsevier, vol. 62(12), pages 1358-1363, December.
    12. Henderson, Brian J. & Zhao, Bo, 2014. "More than meets the eye: Convertible bond issuers' concurrent transactions," Journal of Corporate Finance, Elsevier, vol. 24(C), pages 57-79.
    13. Arnold R. Cowan, 1996. "Convertible Exchangeable Preferred Stock," Finance 9606001, University Library of Munich, Germany, revised 12 Aug 1996.
    14. Anton Miglo, 2008. "Project financing versus corporate financing under asymmetric information," Working Papers 0812, University of Guelph, Department of Economics and Finance.
    15. Krishnaswami, Sudha & Yaman, Devrim, 2008. "The role of convertible bonds in alleviating contracting costs," The Quarterly Review of Economics and Finance, Elsevier, vol. 48(4), pages 792-816, November.

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