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A theory of mandatory convertibles

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  • Chemmanur, Thomas J.
  • Nandy, Debarshi
  • Yan, An
  • Jiao, Jie

Abstract

The objective of this paper is to develop a theoretical analysis of “mandatory convertibles,” which are securities that automatically (“mandatorily”) convert to common stock on a pre-specified date. We consider a firm facing a financial market characterized by asymmetric information and significant costs in the event of financial distress. The firm can raise capital either by issuing mandatory convertibles, or by issuing more conventional securities like straight debt, ordinary convertibles, or equity. We show that, in equilibrium, the firm issues straight debt or ordinary convertibles if the extent of asymmetric information facing it is large, but the probability of being in financial distress is relatively small; it issues mandatory convertibles if it faces a smaller extent of asymmetric information but a greater probability of financial distress. Our model provides a rationale for the three commonly observed features of mandatory convertibles: mandatory conversion, capped (or limited) capital appreciation, and a higher dividend yield compared to common stock. We also characterize the equilibrium design of mandatory convertibles.

Suggested Citation

  • Chemmanur, Thomas J. & Nandy, Debarshi & Yan, An & Jiao, Jie, 2014. "A theory of mandatory convertibles," Journal of Banking & Finance, Elsevier, vol. 42(C), pages 352-370.
    • Handle: RePEc:eee:jbfina:v:42:y:2014:i:c:p:352-370
    DOI: 10.1016/j.jbankfin.2014.01.024
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    Cited by:

    1. Angel Huerga & Carlos Rodríguez-Monroy, 2019. "Mandatory Convertible Bonds and the Agency Problem," Sustainability, MDPI, vol. 11(15), pages 1-21, July.
    2. Angel Huerga & Carlos Rodríguez-Monroy, 2019. "Mandatory Convertible Notes as a Sustainable Corporate Finance Instrument," Sustainability, MDPI, vol. 11(3), pages 1-26, February.
    3. Liu, Liang-Chih & Dai, Tian-Shyr & Zhou, Lei, 2024. "On the design of bail-in-able bonds from the perspective of non-financial firms," International Review of Economics & Finance, Elsevier, vol. 89(PA), pages 1136-1155.
    4. Juan David González-Ruiz & Maria Isabel Acosta-García & Ramón Villa-García, 2021. "Financial Behaviour in a Mandatory Conversion Process: Empirical Evidence from Colombia," Global Business Review, International Management Institute, vol. 22(1), pages 69-84, February.

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    More about this item

    Keywords

    Asymmetric information; Mandatory convertibles; Ordinary convertibles;
    All these keywords.

    JEL classification:

    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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