Strategic Analysis of Risk-Shifting Incentives with Convertible Debt

Pascal François (), Georges Hübner and Nicolas Papageorgiou
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Pascal François: HEC Montréal and CIRPÉE, Department of Finance, 3000 Cote-Ste-Catherine, H3T 2A7 Montreal, Canada
Nicolas Papageorgiou: HEC Montréal and CIRPÉE, Canada

Quarterly Journal of Finance (QJF), 2011, vol. 01, issue 02, 293-321

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.

Keywords: Convertible debt; risk-shifting; noncooperative game (search for similar items in EconPapers)
Date: 2011
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DOI: 10.1142/S2010139211000079

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