SECURITY DESIGN THAT ADDRESSES AGENCY CONFLICTS AND INFORMATION ASYMMETRY

This study focuses on the role of structured derivative securities to meet diverse corporate financing objectives in the light of agency theory and asymmetric information. The focus is on the nonconvertible callable-puttable fixed-coupon bonds. The primary objective is to discern the marginal role of the put and put-deferred features in addressing the agency issues and asymmetric information. A sample of (159) securities issued over the period (1977-2005) are examined using Merton's (1974) structural contingent claims valuation model. The put option as well as the deferred put option incorporated in these securities is found to mitigate the asset substitution issue. It is also found that these contract features provide considerable insurance against the asymmetric information about the firm's downside risk. Specifically, the effects of asset substitution are mitigated because the put option reduces sensitivity of the security's value to the changes in the firm's volatility. Prior to this study, this effect was believed to be driven primarily by the conversion feature in the convertible bonds and the preferred stocks. In addition, the long-term performance of the underlying common stock indicates systematic negative performance for the protracted periods both prior and subsequent to the issuance, yet it is found that this decline in the equity value has only a limited negative impact on the security.