FINANCING UNDER ASYMMETRIC

INFORMATION

3th set of transparencies for ToCF

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INTRODUCTION2 types of asymmetric information

I.

investors / insiders among investorsLEMONS WINNER'S CURSE

Issue of claims may be motivated by insurance project financing, liquidity need

Asymmetry of information about

value of assets in place, prospects attached to new investment, quality of collateral.

level riskiness

Two themes:(1)market breakdown

(2)costly signaling

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Asymmetric information may account for a number of observations, e.g.,:

negative stock price reaction to equity issuance (and smaller reaction during booms),

pecking-order hypothesis (issue low-information-intensity securities first),

market timing.

Asymmetric information predicts dissipative signals (besides lack of financing), e.g.:

private placements, limited diversification, insufficient liquidity, dividend distribution, excess collateralization, underpricing.

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MARKET BREAKDOWNII.

Privately-known-prospects model

• Wealth A = 0, investment cost I.• Project succeeds (R) or fails (0).• Risk neutrality, LL, and zero interest rate in economy.• No moral hazard.

Two borrower types

either pR > I > qR (only good type is creditworthy)

or pR > q R > I (both types are creditworthy)

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Symmetric information benchmark

Cross subsidy:

• • Not incentive compatible under asymmetric information.

Asymmetric information

Overinvestment if bad borrower is not credit worthy.

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Measure of adverse selection

Counterpart of agency cost under moral hazard

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(1) Market timing

Good borrower can refuse to be financed. Hence pooling only if:

Extensions

Financing feasible when ( m + ) R I.Adverse selection parameter smaller in booms ( large).

(2) Negative stock price reaction and going public decision

Entrepreneur already has an existing project, with probability of success p or q.

Deepening investment would increase probability of success by

Financing?

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Separating equilibrium (only bad borrower raises funds)

Negative stock price reaction upon issuance.

(3) Pecking-order hypothesis (Myers 1984)

“information sensitivity”

(1) internal finance

(2) senior debt

(3) junior debt, convertible

(4) equity (“last resort”)

Entrepreneur’s cash

Retained earnings

Information free?

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Payoff in case of failure is now RF > 0Payoff in case of success is RS = RF + R.

Max {good borrower's payoff}s.t.investors break even in expectation

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Unlimited amount of collateral

RESPONSES TO THE LEMONS PROBLEMII.

COSTLY COLLATERAL PLEDGING

PRIVATELY-KNOWN-PROSPECTS MODEL

No moral hazard

probability p or q

good type

bad type

R0

Pledge value C ( < C )for investors

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SYMMETRIC INFORMATION

Assume both types are creditworthy they don’t pledge collateral.

Allocation is not incentive compatible under AI.

Define

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ASYMMETRIC INFORMATION

Separating allocation:

and

Both constraints must be binding 2 equations with 2 unknowns

Note: safe payment

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DETERMINANTS OF COLLATERALIZATION

Positive covariation collateral-quality of borrower (NPV)

more collateral

SEPARATING ALLOCATION UNIQUE EQUILIBRIUM IF

where

Z: conditional on Suppose (to the contrary) q small, then no need for collateral.

p fixed, more collateral

(agency problem )

Z: MH story reverse conclusion! Collateral boosts debt capacity (MH: bad borrower defined as one who does not get funded if he does not pledge collateral).

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General idea: good borrower tries to signal good prospects by increasing the sensitivity of his own returns to the privy information reducing the investors’ claims’ sensitivity to this information.

LOW INFORMATION INTENSITY SECURITIESIV

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ARE LOW INFORMATION INTENSITY CLAIMS

ALWAYS DEBT CLAIMS?

No:

LOutcome M H

“good type”(higher expected returns)

“bad type”

Suboptimal risk sharing Leland-Pyle 1977. Underpricing. ST financing, Monitoring (certification).

OTHER SIGNALING DEVICES

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APPENDIX 1

Hard to have separation:

PRIVATELY-KNOWN-PRIVATE-BENEFIT MODEL WITH MORAL HAZARD

Only borrower knows BA=0

bad type's utility good type's

Model

Outcome

Probability : BL

Probability 1 : BH

BH > BL

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Assumptions

(Only "good type" gets financed under SI)

Pooling. Define by

investors lose money

Only possibility:

no lending (breakdown)

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lending possible

BEST EQUILIBRIUM (for borrower) :

Cross-subsidies

where

"Reduced quality of lending" (relative to SI)

reduced NPV.

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(generalizes to n types)

2 types

Contractual terms (possibly random) : c

Example: c = Rb

b probability b probability 1-~

APPENDIX 2

CONTRACT DESIGN BY AN INFORMED PARTY (ADVANCED)

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etc.

Example : privately-known-private-benefit model

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c tailored for b

tailored for

ISSUANCE GAME

Borrower offerscontract

Investors accept / refuse

(If acceptance) borrower exercises option

Remarks:

can be "no funding"

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DEFINITIONS

Note: first and third necessary conditions for equilibrium behavior.

is

INCENTIVE COMPATIBLE IF

PROFITABLE TYPE-BY-TYPE IF

PROFITABLE IN EXPECTATION IF

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Interim efficient allocation= undominated in the set of allocations that are IC and profitable

in expectation.

Remark: profitable type-by-type is not "information intensive" (is "safe", "belief free").

LOW INFORMATION INTENSITY OPTIMUM (LIIO) FOR TYPE b:

Payoff where c0 maximizes b’s utility in set of allocations that are IC and profitable type-by-type:

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Similar definition for

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Lemma: LIIO is incentive compatible.

Proof: Suppose, e.g., that Consider solution of LIIO program for b:

Intuition: same constraints for both programs.

BORROWER CAN GUARANTEE HIMSELF HIS LIIO.

(1) Issuance game has unique PBE if LIIO interim efficient

(2) If LIIO interim inefficient, set of equilibrium payoffs = feasible

payoffs that dominate LIIO payoffs.

PROPOSITION

not LIIO for after all.

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SYMMETRIC INFORMATION ALLOCATION

ASSUMPTION: (very weak): MONOTONICITY / TYPE:

solves

and similarly for

(always satisfied if not creditworthy, for example).

SEPARATING ALLOCATION

must get at least this in equilibrium

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PROPOSITION: under monotonicity assumption

Proof:LIIO= separating allocation

IC by definition (note could offer )

Type b can get the separating payoff: offers

Type can get offers which is safe for investors.

both types prefer (at least weakly) separating allocation to LIIO.

LIIO

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with

PROPOSITION: under monotonicity assumption

Optimum of this program:

SEPARATING ALLOCATION (LIIO) IS INTERIM EFFICIENT IFF

Consider

constraints satisfied for

separating equilibriumimpossible

constraints satisfied for ' > .