Asset substitution

Asset substitution

Occurs when a firm invests in assets that are riskier than those that the debtholders expected.

Asset Substitution

A company's exchange of lower-risk investments for higher-risk investments. Firms may use asset substitution as a form of financing, or as a move to please shareholders. It can be detrimental to the company's bondholders as it increases the possibility of default without any corresponding benefit because bonds have a fixed interest rate. On the other hand, asset substitution can benefit shareholders as it carries the possibility of higher returns.
References in periodicals archive ?
No asset substitution. Even when the customer has determined that an asset has been explicitly or implicitly specified, the asset is not considered identified if the supplier has a substantive right to substitute another asset to fulfill its obligations under the contract.
Using bank-level data in the third chapter, Phetsathaphone Keovongvichith finds that for a long time, dollarization in the form of FCD holdings by individuals acted as a means of asset substitution (fixed assets) in Lao PDR.
Bernanke explained that this would be reinforced by what he called the "asset substitution effect" in which the reduced availability of bonds in which to invest would cause households to shift their portfolios to equities.
Other key benefits include extension of weighted average tenor of outstanding debt to 4.2 years and a smoother refinancing profile; securing long-term, fixed-rate funding at competitive rates; improved asset substitution flexibility to facilitate ongoing portfolio management initiatives like an asset recycling programme; diversification of financing sources to a broader base of local and international banks, as well as US insurance companies; and a more efficient and flexible balance sheet that lowers surplus cash and adds a revolving credit facility for liquidity requirements.
One of them, the asset substitution hypothesis, argues that shareholders may increase debt due to the unbalanced distribution of benefits and risks around investment projects financed with external capital (Jensen and Meckling,1976).
They argued that diversified equity holders have incentives to expropriate bondholder wealth by investing in risky, high-expected return projects (asset substitution).
The sale and lease-back arrangement is such a method of asset substitution. Stockholders and managers can sell a physical asset and invest the proceeds in a high-risk, high-return project.
Asset managers may indulge in three types of opportunistic behavior due to a reward scheme based on an asymmetric performance fee: 1) they may increase the risk of the fund, especially if no appropriate correction for it is adopted in calculating the incentive fee as happens in the Italian mutual fund industry that we analyze (standard asset substitution risk); 2) they may manage a portfolio of funds with identical investment objectives taking care to minimize their funds' correlations to stabilize their income from performance fees (portfolio asset substitution risk); or 3) they may alter, according to the fund's realized performance, the risk profile of the fund when approaching the end of the incentive fee calculation period (dynamic asset substitution risk).
In Chapter 7, two classic agency problems are considered: the asset substitution problem where the investors do not know whether the firm invests in the riskier project or not, and the underinvestment problem, where the conflict between shareholders and bondholders results from the sharing of the benefits of a new project, even when this is appropriately valued in financial markets.
The new Asset Substitution Product gives qualified borrowers a unique advantage.
Kalay, 1983, "On the Asset Substitution Problem", Journal of Financial and Quantitative Analysis, 18:21-30
Keywords: dollarization, currency substitution, asset substitution, foreign currency, transition economies, Armenia