Optimal Investment with Stock Repurchase and Financing as Signals

Constantinides, George M.; Grundy, Bruce D.

doi:10.1093/rfs/2.4.445

Cited by 244 publications

(129 citation statements)

References 36 publications

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“…Firms can also enjoy certain benefits from issuing CBs. These include reduction in the agency cost of debt (Green, 1984;Jensen and Meckling, 1976), mitigation of underinvestment problem due to adverse selection (Brennan and Kraus, 1987;Brennan and Schwartz, 1988;Constantinides and Grundy, 1989), avoidance of high costs of direct equity sales (Brown et al, 2010;Stein, 1992), and reduction of the costs of sequential financing while controlling overinvestment incentives (Mayers, 1998). Firms will only issue CBs if these benefits exceed the costs of issuing CBs.…”

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confidence: 99%

Risk and return in convertible arbitrage: Evidence from the convertible bond market

Agarwal

Fung

Loon

et al. 2011

Journal of Empirical Finance

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In this paper, we identify and document the empirical characteristics of the key drivers of convertible arbitrage as a strategy and how they impact the performance of convertible arbitrage hedge funds. We show that the returns of a buy-and-hedge strategy involving taking a long position in convertible bonds ("CBs") while hedging the equity risk alone explains a substantial amount of these funds' return dynamics. In addition, we highlight the importance of non-price variables such as extreme market-wide events and the supply of CBs on performance. Out-ofsample tests provide corroborative evidence on our model's predictions. At a more micro level, larger funds appear to be less dependent on directional exposure to CBs and more active in shorting stocks to hedge their exposure than smaller funds. They are also more vulnerable to supply shocks in the CB market. These findings are consistent with economies of scale that large funds enjoy in accessing the stock loan market. However, the friction involved in adjusting the stock of risk capital managed by a large fund can negatively impact performance when the supply of CBs declines. Taken together, our findings are consistent with convertible arbitrageurs collectively being rewarded for playing an intermediation role of funding CB issuers whilst distributing part of the equity risk of CBs to the equity market.Keywords: Hedge funds, Convertible Bonds, Convertible arbitrage, Supply, Risk Factors JEL classification: G10, G19, G23 1 IntroductionAt the turn of the century, capitalization of the global convertible bond ("CB") market stood at just under $300 billion while the US equity market was more than 50 times higher at over $1.5 trillion. Yet during the difficult market conditions between 2000 and 2002 (with events such as end to the dotcom bubble, September 11, and the accounting scandals at Worldcom and Enron), the new issues in both these markets were of similar orders of magnitude-close to $300 billion. Even during the financial crisis of [2007][2008], firms managed to raise about $118 billion in the US CB market. 1 This underscores the importance of the CB market as a source of capital for corporations during adverse economic conditions. 2To smooth the placement of such a large-scale issuance of CBs, economic agents willing to assume the inventory risk are clearly needed. Coincident to these macro events, the last decade has witnessed a rapid growth of convertible arbitrage ("CA 1 Equity data are from Federal Reserve Bulletin (various issues). We thank Jeff Wurgler for making it available on his website http://pages.stern.nyu.edu/~jwurgler/. CB estimate is from the public and private proceeds of convertible debt from Thomson Reuters Financial's SDC Platinum database, which we also use later on for our out-of-sample analysis. 2 Apart from being a useful source of liquidity to issuers during adverse market conditions, the issuance of CBs depends also on the costs and benefits compared to other forms of securities issuance. Firms selling CBs incur costs inclu...

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confidence: 99%

Risk and return in convertible arbitrage: Evidence from the convertible bond market

Agarwal

Fung

Loon

et al. 2011

Journal of Empirical Finance

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“…Also see Dyer, Kale and Singh (2001) and Keasler and Denning (2009) for alliances; Allen and McConnell (1998) for carve-outs; Desai and Jain (1999) and Daley, Mehrotra and Sivakumar (1997) for spinoffs. 9 For some examples refer to Bradley, Dsai and Kim (1983) and Lakonishok and Vermaelen (1990) for tender offers; Constantinides and Grundy (1989) and Ikenberry, Lakonishok and Vermaelen (1995) for repurchases; Masulis (1980) and Copeland and Lee (1991) for Exchanges; and Dann and Mikkelson (1984) for capital structure changes. 10 See Chen, Mehrotra, Sivakumar and Yu (2001).…”

Section: Business and Economic Researchmentioning

confidence: 99%

Divergent Market Responses to Human Capital Reorganizations

Cowan

Denning

Anderson

et al. 2018

BER

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“…A common theme of existing works is that convertible securities help to mitigate various agency problems, which typically arise under asymmetric information. In particular, convertible securities are shown to mitigate the asset substitution problem (Green (1984)), windowdressing behavior (Cornelli and Yosha (2003)), inefficient investment (Schmidt (2003)), the underinvestment problem (Lyandres and Zhdanov (2014)), and other asymmetric informa-tion problems (Constantinides and Grundy (1989), Stein (1992), Repullo and Suarez (2004), Hellmann (2006), Chakraborty and Yilmaz (2011)). Our analysis shows that convertible securities also have an economic role when agency conflicts are absent, as is the case in our model.…”

Section: Introductionmentioning

confidence: 99%

Security Design with Status Concerns

et al. 2015

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This paper provides a status-based explanation for convertible securities. We consider a dynamic setting in which a status-driven entrepreneur with a project idea decides what security to issue to finance the project and how to manage the project over time. We solve the problem analytically and find that the optimal security is considerably similar to a convertible security. Our model can also explain why relatively riskier companies, such as start-ups or small firms, resort to convertible securities more often, as well as why these securities differ in their conversion ratios. The dynamic nature of our model is key to our results whereas asymmetric information and ensuing agency conflicts play no role, which makes our explanation of convertible securities notably different from existing ones.JEL Classifications: G32, C61, G24, D86.

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Optimal Investment with Stock Repurchase and Financing as Signals

Cited by 244 publications

References 36 publications

Risk and return in convertible arbitrage: Evidence from the convertible bond market

Risk and return in convertible arbitrage: Evidence from the convertible bond market

Divergent Market Responses to Human Capital Reorganizations

Security Design with Status Concerns

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