Hostname: page-component-8448b6f56d-t5pn6 Total loading time: 0 Render date: 2024-04-19T08:17:31.581Z Has data issue: false hasContentIssue false
  • English
  • Français

Asset Substitution and Structured Financing

Published online by Cambridge University Press:  01 August 2009

Joel M. Vanden
Joel M. Vanden*
Affiliation:
Smeal College of Business, Pennsylvania State University, 341 Business Bldg., University Park, PA 16802. jmv13@psu.edu
Get access Rights & Permissions [Opens in a new window]

Abstract

This article shows how structured financing can be used to solve the asset substitution problem in a dynamic setting. Structuring induces the firm’s owner to optimally choose the first best operating strategy even though the owner’s value function might be locally convex (concave), which would ordinarily lead to overinvestment (underinvestment) in risky projects. This result is demonstrated in two different continuous time settings—one that is based on the risk-shifting framework of Leland (1998) and one that generalizes the scaled return model of Green (1984). It is shown that the contractual nature of the structuring is a key determinant of the issuing firm’s dynamic asset volatility. Furthermore, unlike nonstructured financing, the default (conversion) probability of a structured debt security may be increasing (decreasing) in the firm’s total assets. Structured securities are therefore hedge assets, which potentially explains the popularity of structured securities among investors and third-party issuers.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 44 , Issue 4 , August 2009 , pp. 911 - 951
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2009

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Barber, B. “Exchangeable Debt.” Financial Management, 22 (1993), 48–60.CrossRefGoogle Scholar
Barclay, M., and Smith, C.. “The Maturity Structure of Corporate Debt.” Journal of Finance, 50 (1995), 609–631.CrossRefGoogle Scholar
Barclay, M.; Smith, C.; and Morellec, E.. “On the Debt Capacity of Growth Options.” Journal of Business, 79 (2006), 37–59.CrossRefGoogle Scholar
Barnea, A.; Haugen, R.; and Senbet, L.. “A Rationale for Debt Maturity Structure and Call Provisions in the Agency Theoretic Framework.” Journal of Finance, 35 (1980), 1223–1234.CrossRefGoogle Scholar
Benet, B.; Giannetti, A.; and Pissaris, S.. “Gains From Structured Product Markets: The Case of Reverse Exchangeable Securities.” Journal of Banking and Finance, 30 (2006), 111–132.CrossRefGoogle Scholar
Black, F., and Cox, J.. “Valuing Corporate Securities: Some Effects of Bond Indenture Provisions.” Journal of Finance, 31 (1976), 351–367.CrossRefGoogle Scholar
Black, F., and Scholes, M.. “The Pricing of Options and Corporate Liabilities.” Journal of Political Economy, 81 (1973), 637–654.CrossRefGoogle Scholar
Brennan, M., and Schwartz, E.. “Analyzing Convertible Bonds.” Journal of Financial and Quantitative Analysis, 15 (1980), 907–929.CrossRefGoogle Scholar
Brennan, M., and Schwartz, E.. “The Case for Convertibles.” Chase Financial Quarterly, 1 (1982), 27–46.Google Scholar
Carlson, M., and Lazrak, A.. “Leverage Choice and Credit Spread Dynamics when Managers Risk Shift.” Working Paper, University of British Columbia (2006).CrossRefGoogle Scholar
Chen, K., and Sears, R.. “Pricing the SPIN.” Financial Management, 19 (1990), 36–47.CrossRefGoogle Scholar
Chesney, M., and Gibson-Asner, R.. “Reducing Asset Substitution with Warrant and Convertible Debt Issues.” Journal of Derivatives, 9 (2001), 39–52.CrossRefGoogle Scholar
Chidambaran, N.; Fernando, C.; and Spindt, P.. “Credit Enhancement through Financial Engineering: Freeport McMoRan’s Gold-Denominated Depository Shares.” Working Paper, University of Pennsylvania (1999).CrossRefGoogle Scholar
Chidambaran, N.; Fernando, C.; and Spindt, P.. “Credit Enhancement through Financial Engineering: Freeport McMoRan’s Gold-Denominated Depositary Shares.” Journal of Financial Economics, 60 (2001), 487–528.CrossRefGoogle Scholar
Childs, P.; Mauer, D.; and Ott, S.. “Interactions of Corporate Financing and Investment Decisions: The Effects of Agency Conflicts.” Journal of Financial Economics, 76 (2005), 667–690.CrossRefGoogle Scholar
Décamps, J., and Djembissi, B.. “Switching to a Poor Business Activity: Optimal Capital Structure, Agency Costs, and Covenant Rules.” Annals of Finance, 3 (2007), 389–409.CrossRefGoogle Scholar
Ericsson, J. “Asset Substitution, Debt Pricing, Optimal Leverage, and Maturity.” Finance, 21 (2000), 39–70.Google Scholar
Finnerty, J. “Interpreting SIGNs.” Financial Management, 22 (1993), 34–47.CrossRefGoogle Scholar
Flannery, M. “No Pain, No Gain? Effecting Market Discipline via ‘Reverse Convertible Debentures’.” In Capital Adequacy Beyond Basel: Banking, Securities, and Insurance, Scott, H. S., ed. New York, NY: Oxford University Press (2005).Google Scholar
Gavish, B., and Kalay, A.. “On the Asset Substitution Problem.” Journal of Financial and Quantitative Analysis, 18 (1983), 21–30.CrossRefGoogle Scholar
Gorton, G., and Pennacchi, G.. “Security Baskets and Index-Linked Securities.” Journal of Business, 66 (1993), 1–27.CrossRefGoogle Scholar
Graham, J., and Harvey, C.. “The Theory and Practice of Corporate Finance: Evidence from the Field.” Journal of Financial Economics, 60 (2001), 187–243.CrossRefGoogle Scholar
Green, R. “Investment Incentives, Debt, and Warrants.” Journal of Financial Economics, 13 (1984), 115–136.CrossRefGoogle Scholar
Green, R., and Talmor, E.. “Asset Substitution and the Agency Costs of Debt Financing.” Journal of Banking and Finance, 10 (1986), 391–399.CrossRefGoogle Scholar
Haugen, R., and Senbet, L.. “Resolving the Agency Problems of External Capital through Options.” Journal of Finance, 36 (1981), 629–647.CrossRefGoogle Scholar
Hennessy, C., and Tserlukevich, Y.. “Taxation, Agency Conflicts, and the Choice between Callable and Convertible Debt.” Journal of Economic Theory, 143 (2008), 374–404.CrossRefGoogle Scholar
Hillion, P., and Vermaelen, T.. “Death Spiral Convertibles.” Journal of Financial Economics, 71 (2004), 381–415.CrossRefGoogle Scholar
Ingersoll, J. “A Contingent Claims-Valuation of Convertible Securities.” Journal of Financial Economics, 4 (1977), 289–321.CrossRefGoogle Scholar
Jensen, M., and Meckling, W.. “The Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure.” Journal of Financial Economics, 3 (1976), 305–360.CrossRefGoogle Scholar
John, K. “Risk-Shifting Incentives and Signalling through Corporate Capital Structure.” Journal of Finance, 42 (1987), 623–641.Google Scholar
Ju, N., and Ou-Yang, H.. “Asset Substitution and Underinvestment: A Dynamic View.” Working Paper, Duke University (2005).CrossRefGoogle Scholar
Karatzas, I., and Shreve, S.. Brownian Motion and Stochastic Calculus, 2nd ed.New York: Springer (1991).Google Scholar
Leary, M., and Roberts, M.. “Do Firms Rebalance Their Capital Structures?” Journal of Finance, 60 (2005), 2575–2619.CrossRefGoogle Scholar
Leland, H. “Agency Costs, Risk Measurement, and Capital Structure.” Journal of Finance, 53 (1998), 1213–1243.CrossRefGoogle Scholar
MacKay, P. “Real Flexibility and Financial Structure: An Empirical Analysis.” Review of Financial Studies, 16 (2003), 1131–1165.CrossRefGoogle Scholar
Manso, G.; Strulovici, B.; and Tchistyi, A.. “Performance-Sensitive Debt.” Working Paper, Massachusetts Institute of Technology (2006).Google Scholar
Mauer, D., and Sarkar, S.. “Real Options, Agency Conflicts, and Optimal Capital Structure.” Journal of Banking and Finance, 29 (2005), 1405–1428.CrossRefGoogle Scholar
Mauer, D., and Triantis, A.. “Interactions of Corporate Financing and Investment Decisions: A Dynamic Framework.” Journal of Finance, 49 (1994), 1253–1277.CrossRefGoogle Scholar
McCann, K., and Cilia, J.. “Structured Notes.” Federal Reserve Bank of Chicago (1994).Google Scholar
McConnell, J., and Schwartz, E.. “LYON Taming.” Journal of Finance, 41 (1986), 561–576.CrossRefGoogle Scholar
Mello, A., and Parsons, J.. “Measuring the Agency Cost of Debt.” Journal of Finance, 47 (1992), 1887–1904.CrossRefGoogle Scholar
Myers, S. “Determinants of Corporate Borrowing.” Journal of Financial Economics, 5 (1977), 147–175.CrossRefGoogle Scholar
Nachman, D., and Noe, T.. “Asymmetric Information, Asset Substitution, and the Design of Securities.” Advances in Financial Economics, 2 (1996), 151–186.Google Scholar
Parrino, R., and Weisbach, M.. “Measuring Investment Distortions Arising from Stockholder- Bondholder Conflicts.” Journal of Financial Economics, 53 (1999), 3–42.CrossRefGoogle Scholar
Schultz, P. “Calls of Warrants: Timing and Market Reaction.” Journal of Finance, 48 (1993), 681–696.CrossRefGoogle Scholar
Smith, C., and Stulz, R.. “The Determinants of Firms’ Hedging Policies.” Journal of Financial and Quantitative Analysis, 20 (1985), 391–405.CrossRefGoogle Scholar
Smith, C., and Warner, J.. “On Financial Contracting: An Analysis of Bond Covenants.” Journal of Financial Economics, 7 (1979), 117–161.CrossRefGoogle Scholar
Smithson, C., and Chew, D.. “The Uses of Hybrid Debt in Managing Corporate Risk.” Journal of Applied Corporate Finance, 4 (1992), 79–89.CrossRefGoogle Scholar
Spatt, C., and Sterbenz, F.. “Incentive Conflicts, Bundling Claims, and the Interaction among Financial Claimants.” Journal of Finance, 48 (1993), 513–528.CrossRefGoogle Scholar
Stohs, M., and Mauer, D.. “The Determinants of Corporate Debt Maturity Structure.” Journal of Business, 69 (1996), 279–312.CrossRefGoogle Scholar
Stoimenov, P., and Wilkens, S.. “Are Structured Products ‘Fairly’ Priced? An Analysis of the German Market for Equity-Linked Instruments.” Journal of Banking and Finance, 29 (2005), 2971–2993.CrossRefGoogle Scholar
Subramanian, A. “Managerial Incentives, Financing, and Dynamic Investment.” Working Paper, Georgia State University (2005).Google Scholar
Swieringa, R., and Morse, D.. “Accounting for Hybrid Convertible Debentures.” The Accounting Review, 60 (1985), 127–133.Google Scholar
Titman, S., and Wessels, R.. “The Determinants of Capital Structure Choice.” Journal of Finance, 43 (1988), 1–19.CrossRefGoogle Scholar