Game Options Analysis of the Information Role of Call Policies in Convertible Bonds

Abstract: In debt financing, existence of information asymmetry on the firm quality between the firm management and bond investors may lead to significant adverse selection costs. We develop the two-stage sequential dynamic two-person game option models to analyse the market signalling role of the callable feature in convertible bonds. We show that firms with positive private information on earning potential may signal their type to investors via the callable feature in a convertible bond. We present the variational inequalities formulation with respect to various equilibrium strategies in the two-person game option models via characterization of the optimal stopping rules adopted by the bond issuer and bondholders. The bondholders’ belief system on the firm quality may be revealed with the passage of time when the issuer follows his optimal strategy of declaring call or bankruptcy. Under separating equilibrium, the quality status of the firm is revealed so the information asymmetry game becomes a new game under complete information. To analyse pooling equilibrium, the corresponding incentive compatibility constraint is derived. We manage to deduce the sufficient conditions for the existence of signalling equilibrium of our game option model under information asymmetry. We analyse how the callable feature may lower the adverse selection costs in convertible bond financing. We show how a low-quality firm may benefit from information asymmetry and vice versa, underpricing of the value of debt issued by a high-quality firm.