Asymmetric Information and Securit y Design under Knightian Uncertainty (with with Andrey Malenko)
Abstract:
We study optimal security
design by an informed issuer when the investor faces Knightian uncertainty
about the distribution of cash flows from the project and demands robustne
ss: she evaluates each security by the worst-case rationalizable model. In
equilibrium, the security offer affects the investor’s assessment of its va
lue through both the structure of payoffs from the security and signaling o
f the issuer’s private information. When uncertainty is sufficiently high,
standard equity arises as the unique equilibrium security. When uncertainty
is sufficiently small, the equilibrium typically features risky debt. In t
he intermediate case, both risky debt and standard equity arise in equilibr
ium. When private information is about assets in place of the issuer rather
than a new project, standard equity is no longer issued in equilibrium, ir
respective of the level of uncertainty, and the equilibrium (usually) featu
res risky debt.