Mitigating risk incentives by issuing convertible bonds: A refinement to the Black–Scholes evaluation model

Masatoshi Miyake (), Mei Yu () and Hiroshi Inoue ()
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Masatoshi Miyake: Faculty of Human Sciences, Waseda University, Japan
Mei Yu: Department of Financial Engineering School of Finance and Banking, University of International Business and Economics, P. R. China
Hiroshi Inoue: School of Management, Tokyo University of Science, Japan

Journal of Financial Engineering (JFE), 2014, vol. 01, issue 03, 1-17

Abstract: This study employs option pricing theory to analyze the risk incentive conflict between shareholders and creditors. It evaluates the volatility of investment projects funded by borrowed money and compares their gains for the shareholder and creditor. Our analysis is based on the recognition that shareholders' and creditors' objectives may differ. We identify the shareholder's risk incentive as a source of agency cost originating with the shareholder and find that issuing a convertible bond avoids agency cost without diluting existing shareholders' ownership. Numerical examples are shown to examine it.

Keywords: Risk incentive problem; agency cost; shareholder–creditor relationship; convertible bond; option pricing theory; knock-out provision (search for similar items in EconPapers)
Date: 2014
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DOI: 10.1142/S234576861450024X

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