The value of a convertible bond is relatively insensitive to changes in the riskiness of the firm, because the value of the underlying bond is inversely related to changes in the firm's risk, while the value of the implicit call option is directly related to changes in the firm's risk.Consequently, with a convertible bond the firm's management no longer has an incentive to engage in ______to expropriate value from the bondholders, and therefore one of the major agency problems associated with debt is resolved.

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The value of a convertible bond is less sensitive to changes in the firm's risk because the bond component loses value as risk increases (due to higher default risk), while the value of the conversion option (to convert the bond into equity) increases with higher risk (since equity holders benefit from increased volatility). This balance reduces the incentive for management to engage in risk shifting, which is taking on additional risk in an attempt to increase the firm's value at the expense of bondholders.

The Value of a Convertible Bond Is Relatively Insensitive to Changes