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Monday, March 18, 2019 at 11:40am to 1:10pm
Uris Hall, 498
Anton Tsoy, EIEF
Asymmetric Information and Security Design under Knightian Uncertainty (joint w/Andrey Malenko)
Abstract: We study a signaling game in which an issuer with private information about the distribution of the project's cash flows designs a security to sell to an uninformed investor to raise financing for the project. The investor faces Knightian uncertainty and evaluates each security by the worst-case distribution at which she could justify the security being offered by the issuer. First, we show that both standard outside equity and standard risky debt arise as equilibrium securities. Thus, the model provides a common foundation for two most widespread financial contracts based on one market imperfection, information asymmetry. Second, we show that the equilibrium security differs depending on the degree of uncertainty and on whether issuer's private information and investor's uncertainty concern a new project or assets in place. If private information concerns a new project and uncertainty is sufficiently high, standard outside equity arises in equilibrium. When uncertainty is sufficiently small, the equilibrium typically features risky debt and never outside equity. In the intermediate case, both risky debt and standard equity arise in equilibrium. In contrast, if private information concerns assets in place, standard equity is never issued in equilibrium, irrespective of the level of uncertainty, and the equilibrium security is (usually) risky debt.