Journal Article

Adverse Selection and Convertible Bonds

Archishman Chakraborty and Bilge Yilmaz

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 78, issue 1, pages 148-175
Published in print January 2011 | ISSN: 0034-6527
Published online January 2011 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1093/restud/rdq002
Adverse Selection and Convertible Bonds

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  • Information, Knowledge, and Uncertainy
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Informational asymmetries between a firm and investors may lead to adverse selection in capital markets. This paper demonstrates that when the market obtains noisy information about a firm over time, this adverse selection problem can be costlessly solved by issuing callable convertible bonds with restrictive call provisions. Such securities can be designed to make the payoff to new claimholders independent of the private information of the manager. This eliminates the possibility of any dilution of equity or underinvestment and implements the symmetric information outcome in either a pooling or a separating equilibrium. The same first-best efficient outcome can also be implemented by issuing floating-price and mandatory convertibles.

Keywords: Adverse selection; Underinvestment; Efficient financing; G32; D82; D86

Journal Article.  16191 words.  Illustrated.

Subjects: Information, Knowledge, and Uncertainy ; Corporate Governance

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