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Optimal security design under asymmetric information and profit manipulation
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Koufopoulos, Kostas, Kozhan, Roman and Trigilia, Giulio (2014) Optimal security design under asymmetric information and profit manipulation. Working Paper. Coventry: University of Warwick. Department of Economics. Warwick economics research papers series (TWERPS), Volume 2014 (Number 1050). (Unpublished)
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Official URL: http://www2.warwick.ac.uk/fac/soc/economics/resear...
Abstract
We consider a model of external financing under ex ante asymmetric information and profit manipulation (non verifability). Contrary to conventional wisdom, the optimal contract is not standard debt, and it is not monotonic. Instead, it resembles a contingent convertible (CoCo) bond. In particular: (i) if the profit manipulation and/or adverse selection are not severe, there exists a unique separating equilibrium in CoCos; (ii) in the intermediate region, if the distribution of earnings is unbounded above there exists a unique pooling equilibrium in CoCos, otherwise debt might be issued but it is never the unique equilibrium; (iii) finally, if profit manipulation is severe, there is no financing
These findings suggest that the standard monotonicity constraint exogenously imposed in the security design literature must be reconsidered. Crucially, profit manipulation is part of the optimal contract, and non-monotonic, convertible securities mitigate the asymmetric information problem. We discuss milestone payments in venture capital as an application.
Item Type: | Working or Discussion Paper (Working Paper) | ||||
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Subjects: | H Social Sciences > HG Finance | ||||
Divisions: | Faculty of Social Sciences > Economics Faculty of Social Sciences > Warwick Business School > Finance Group Faculty of Social Sciences > Warwick Business School |
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Library of Congress Subject Headings (LCSH): | Business enterprises -- Finance, Information asymmetry, Debts, External | ||||
Series Name: | Warwick economics research papers series (TWERPS) | ||||
Publisher: | University of Warwick. Department of Economics | ||||
Place of Publication: | Coventry | ||||
Official Date: | July 2014 | ||||
Dates: |
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Volume: | Volume 2014 | ||||
Number: | Number 1050 | ||||
Number of Pages: | 30 | ||||
Institution: | University of Warwick | ||||
Status: | Not Peer Reviewed | ||||
Publication Status: | Unpublished | ||||
Access rights to Published version: | Open Access (Creative Commons) | ||||
Date of first compliant deposit: | 28 July 2016 | ||||
Date of first compliant Open Access: | 28 July 2016 |
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