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Convertible Bond Underpricing: Renegotiable Covenants, Seasoning and Convergence

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Listed author(s):
  • Alex W.H. Chan

    (School of Economics and Finance, University of Hong Kong)

  • Nai-fu Chen

    (Center for Advanced Research Finance, University of Tokyo)

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    Abstract

    We investigate the long-standing puzzle on the underpricings of convertible bonds. We hypothesize that the observed underpricing is induced by the possibility that a convertible bond might renegotiate on some of its covenants, e.g., an imbedded put option, in financial difficulties. Consistent with our hypothesis, we find that the initial underpricing is larger for lower rated bonds. The underpricing worsens if the issuer experiences subsequent financial difficulties. However, conditional on no rating downgrades, our main empirical result shows that convertible bond prices do converge to their theoretical prices within two years. This seasoning period is shorter for higher rated convertible bonds.

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    File URL: http://www.cirje.e.u-tokyo.ac.jp/research/dp/2006/2006cf437.pdf
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    Paper provided by CIRJE, Faculty of Economics, University of Tokyo in its series CIRJE F-Series with number CIRJE-F-437.

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    Length: 61pages
    Date of creation: Oct 2006
    Handle: RePEc:tky:fseres:2006cf437
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    7. Ingersoll, Jonathan E, Jr, 1977. "An Examination of Corporate Call Policies on Convertible Securities," Journal of Finance, American Finance Association, vol. 32(2), pages 463-478, May.
    8. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    9. 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.
    10. Akihiko Takahashi & Takao Kobayashi & Naruhisa Nakagawa, 2001. "Pricing Convertible Bonds with Default Risk: A Duffie-Singleton Approach," CIRJE F-Series CIRJE-F-140, CIRJE, Faculty of Economics, University of Tokyo.
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