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Asset Substitution and Structured Financing

Published online by Cambridge University Press:  01 August 2009

Joel M. Vanden
Joel M. Vanden*
Affiliation:
Smeal College of Business, Pennsylvania State University, 341 Business Bldg., University Park, PA 16802. jmv13@psu.edu
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Abstract

This article shows how structured financing can be used to solve the asset substitution problem in a dynamic setting. Structuring induces the firm’s owner to optimally choose the first best operating strategy even though the owner’s value function might be locally convex (concave), which would ordinarily lead to overinvestment (underinvestment) in risky projects. This result is demonstrated in two different continuous time settings—one that is based on the risk-shifting framework of Leland (1998) and one that generalizes the scaled return model of Green (1984). It is shown that the contractual nature of the structuring is a key determinant of the issuing firm’s dynamic asset volatility. Furthermore, unlike nonstructured financing, the default (conversion) probability of a structured debt security may be increasing (decreasing) in the firm’s total assets. Structured securities are therefore hedge assets, which potentially explains the popularity of structured securities among investors and third-party issuers.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 44 , Issue 4 , August 2009 , pp. 911 - 951
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2009

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