Document Type

Journal Article

Department/Unit

Department of Mathematics

Title

Game options analysis of the information role of call policies in convertible bonds

Language

English

Abstract

© 2015 Taylor & Francis. Abstract: In debt financing, existence of information asymmetry on the firm quality between the firm management and bond investors may lead to significant adverse selection costs. We develop the two-stage sequential dynamic two-person game option models to analyse the market signalling role of the callable feature in convertible bonds. We show that firms with positive private information on earning potential may signal their type to investors via the callable feature in a convertible bond. We present the variational inequalities formulation with respect to various equilibrium strategies in the two-person game option models via characterization of the optimal stopping rules adopted by the bond issuer and bondholders. The bondholders’ belief system on the firm quality may be revealed with the passage of time when the issuer follows his optimal strategy of declaring call or bankruptcy. Under separating equilibrium, the quality status of the firm is revealed so the information asymmetry game becomes a new game under complete information. To analyse pooling equilibrium, the corresponding incentive compatibility constraint is derived. We manage to deduce the sufficient conditions for the existence of signalling equilibrium of our game option model under information asymmetry. We analyse how the callable feature may lower the adverse selection costs in convertible bond financing. We show how a low-quality firm may benefit from information asymmetry and vice versa, underpricing of the value of debt issued by a high-quality firm.

Keywords

call provision, Convertible bonds, game options, signalling equilibrium

Publication Date

2015

Source Publication Title

Applied Mathematical Finance

Volume

22

Issue

4

Start Page

297

End Page

335

Publisher

Taylor & Francis

DOI

10.1080/1350486X.2015.1040522

Link to Publisher's Edition

http://dx.doi.org/10.1080/1350486X.2015.1040522

ISSN (print)

1350486X

ISSN (electronic)

14664313

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