What Is an Alternative Risk Transfer?

Jensen and Meckling (1976) believe that in an economic environment with incomplete information, the information held by the two parties to the contract is asymmetric, and they are both pursuing utility maximizers. Therefore, agents do not always use Benefit as the highest criterion for their own actions. As the ownership and management rights of most modern companies are separated, the agency relationship between the owner and the operator (ie, shareholders and managers) has arisen. Agency problems arise when the interests of shareholders and managers are inconsistent. On the other hand, when the company adopts debt financing, agency problems may also arise between shareholders and creditors due to inconsistent interests.

Risk transfer hypothesis

Generally speaking, to solve

The risk transfer hypothesis is also known as the asset substitution hypothesis. The hypothesis believes that the motive of the company to issue convertible bonds is to ease the conflict of interest between shareholders and creditors, because it can reduce the incentive for shareholders to plunder the interests of creditors.

One of the potential conflicts between shareholders and creditors stems from the level of risk at which companies execute investments. Shareholders have an incentive to invest in high-risk projects. If the investment is successful, the shareholders will get most of the income; if the investment fails, the creditor may suffer losses in addition to the interest income cannot be guaranteed. Even if the loss in equity is lower than the gains deprived from the debt, shareholders may invest in projects with a negative net cash flow. The problem faced by creditors is called "asset replacement" or "risk transfer". Jensen and Mecking wrote that issuing convertible bonds, rather than bonds, would reduce the incentive for shareholders to rob interests from creditors. This dissertation is supported by research by Smith and Warner, and by Brennan and Schwartz.

The reason why convertible bonds can solve asset substitution is because of its dual attributes. As we all know, convertible bonds are composed of linear bonds and warrants. Since a warrant is a buyer's option, its value will increase as the value of the business changes. Therefore, when the company has convertible bonds in circulation, the shareholders' income from investment projects will be diluted by warrants. As a result, the incentive for shareholders to invest in high-risk projects will be reduced.

The asset replacement hypothesis also predicts that small, young companies with limited physical assets and more growth opportunities, those with higher financial leverage, and are likely to be in financial distress will be more likely to use convertible bonds instead of bonds for financing. These predictions of the asset replacement hypothesis are supported by corresponding research evidence. Brennan, and Essig wrote that convertible bond selection is positively correlated with return volatility. In addition, Ess, Lewis, and others found that convertible bond selection is negatively related to corporate profitability. Taken together, these findings provide evidence to support the asset substitution hypothesis.

Main policy implications

Companies with high financial leverage and high possibility of financial distress;

Companies with a higher percentage of assets in the form of investment options in the company's asset structure;

A small or young company with good growth.