We revisit Stein (1992)’s model and demonstrate that it provides an insufficient justification for the use of callable convertible bonds as financing instruments. A standard convertible bond solves the firm’s financing problem in both the simple and extended versions of the model. More generally, convertibles have little relevance within this model because the firm can finance efficiently with a package of equity and short-term straight debt, the components of which are dynamically adjusted. This package becomes a superior financing strategy in comparison to convertible debt if one relaxes the model’s assumption that the firm can always force conversion.

This paper mathematically transforms unobservable rational expectation equilibrium model parameters (information precision and supply uncertainty) into a single variable that is correlated with expected returns and that can be estimated with recently observed data. Our variable can be used to explain the cross section of returns in theoretical, numerical, and empirical analyses. Using Center for Research in Security Prices data, we show that a −1σ to +1σ change in our variable is associated with a 0.31% difference in average returns the following month (equaling 3.78% per annum). The results are statistically significant at the 1% level. Our results remain economically and statistically significant after controlling for stocks' market capitalizations, book-to-market ratios, liquidities, and the probabilities of information-based trading.