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Informative Conversion Ratios: A Signalling Approach

Published online by Cambridge University Press:  06 April 2009

Yong O. Kim
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Abstract

The paper uses a signalling equilibrium to explain the market's reaction to the announcement of a firm's financing decision. In our model, a firm can issue one of the following securities: convertible debt with a different conversion ratio, straight debt, and stock. We identify conditions under which the conversion ratio of a convertible debt issue serves as a credible signal of a firm's private information, given the continuous distribution of attributes (information) across firms. In this signalling equilibrium, we find that the lower the expected future earnings, the higher the conversion ratio of a convertible debt issue. At the limit, firms that expect the highest earnings will use straight debt financing, and firms that expect the lowest earnings will use equity financing. Based on the signalling equilibrium, we predict that at announcement of a convertible debt issue, negative abnormal common stock return increases in absolute value with the conversion ratio.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 25 , Issue 2 , June 1990 , pp. 229 - 243
Copyright
Copyright © School of Business Administration, University of Washington 1990

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