A Sequential Signalling Model of Convertible Debt Call Policy

Authors

  • MILTON HARRIS,

  • ARTUR RAVIV

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    • Department of Finance, Kellogg Graduate School of Management, Northwestern University and Department of Finance, Kellogg Graduate School of Management, Northwestern University and Faculty of Management, Tel Aviv University, respectively. We are grateful to the National Science Foundation for financial support. We would also like to acknowledge the helpful suggestions of workshop participants at Stanford University, University of California at Berkeley, and the University of Chicago. In particular we thank Sudipto Bhattacharya, Roy Henriksson, M. P. Narayan, Mark Rubinstein, and Myron Scholes for useful comments.


ABSTRACT

In this paper we attempt to resolve two puzzles concerning convertible debt calls. The first is that although it has been shown that conversion of these bonds should optimally be forced as soon as this is feasible, actual calls are significantly delayed relative to this prescription. The second is that common stock returns are significantly negative around the announcement of the call of a convertible debt issue. Our purpose is to simultaneously rationalize managers' observed call decisions and the market's reaction to them in a framework in which managers behave optimally given their private information, compensation schemes, and investors' reactions to their call decisions. Moreover, investors' reactions are rational in the sense of Bayes' rule given managers' call policy. In equilibrium, a decision to call is (correctly) perceived by the market as a signal of unfavorable private information. In addition to rationalizing observed call delays and negative stock returns at call announcement, several other testable implications are derived.

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