FINANCING UNDER ASYMMETRIC INFORMATION 3th set of transparencies for ToCF

I.

2 types of asymmetric information

investors / insiders LEMONS among investors 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 Two themes:(1)market breakdown (2)costly signaling riskiness
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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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II. MARKET BREAKDOWN 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 Not incentive compatible under asymmetric information.

Asymmetric information

Cross subsidy: Overinvestment if bad borrower is not credit worthy.

Measure of adverse selection

Counterpart of agency cost under moral hazard

Extensions (1) Market timing 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? Good borrower can refuse to be financed. Hence pooling only if:
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Separating equilibrium (only bad borrower raises funds) Negative stock price reaction upon issuance. (3) Pecking-order hypothesis (Myers 1984)
(1) internal finance Entrepreneurs cash

Retained earnings Information free?

information sensitivity

(2) senior debt

(3) junior debt, convertible (4) equity (last resort)

 Payoff in case of failure is now RF > 0 Payoff in case of success is RS = RF + R. Max {good borrower's payoff} s.t. investors break even in expectation

II. RESPONSES TO THE LEMONS PROBLEM COSTLY COLLATERAL PLEDGING PRIVATELY-KNOWN-PROSPECTS MODEL No moral hazard

R 0

probability p

or

good type

bad type

Unlimited amount of collateral Pledge value C for investors ( < C )

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SYMMETRIC INFORMATION Assume both types are creditworthy

they dont pledge collateral.

Define

Allocation is not incentive compatible under AI.

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ASYMMETRIC INFORMATION Separating allocation:

Both constraints must be binding

2 equations with 2 unknowns

and

Note:

safe payment

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DETERMINANTS OF COLLATERALIZATION

more collateral p fixed, more collateral (agency problem )

Z: conditional on Suppose (to the contrary) q small, then no need for collateral. Positive covariation collateral-quality of borrower (NPV) 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). SEPARATING ALLOCATION UNIQUE EQUILIBRIUM IF where
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IV LOW INFORMATION INTENSITY SECURITIES 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.

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ARE LOW INFORMATION INTENSITY CLAIMS

ALWAYS DEBT CLAIMS?

No:
Outcome good type (higher expected returns) bad type L M H

OTHER SIGNALING DEVICES Suboptimal risk sharing Leland-Pyle 1977. Underpricing. ST financing, Monitoring (certification).
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APPENDIX 1 PRIVATELY-KNOWN-PRIVATE-BENEFIT MODEL WITH MORAL HAZARD Only borrower knows B A=0 Hard to have separation: 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)

investors lose money Only possibility:

Pooling. Define by

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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APPENDIX 2 CONTRACT DESIGN BY AN INFORMED PARTY (ADVANCED) 2 types b probability ~ b probability 1- (generalizes to n types) Contractual terms (possibly random) : c

Example: c = Rb

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Example : privately-known-private-benefit model

etc.

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ISSUANCE GAME
Borrower offers contract Investors accept / refuse (If acceptance) borrower exercises option

Remarks: c tailored for b tailored for can be "no funding"

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DEFINITIONS
is

INCENTIVE COMPATIBLE IF

PROFITABLE TYPE-BY-TYPE IF

PROFITABLE IN EXPECTATION IF
Note: first and third necessary conditions for equilibrium behavior.

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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 bs 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:

not LIIO for

after all.

Intuition: same constraints for both programs. BORROWER CAN GUARANTEE HIMSELF HIS LIIO. PROPOSITION (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. 25

SYMMETRIC INFORMATION ALLOCATION solves

and similarly for ASSUMPTION: (very weak): MONOTONICITY / TYPE:

(always satisfied if not creditworthy, for example).

SEPARATING ALLOCATION

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must get at least this in equilibrium

PROPOSITION: under monotonicity assumption LIIO= separating allocation Proof:

LIIO both types prefer (at least weakly) separating allocation to LIIO. Type b can get the separating payoff: offers IC by definition (note could offer )
Type can get offers which is safe for investors.

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PROPOSITION: under monotonicity assumption SEPARATING ALLOCATION (LIIO) IS INTERIM EFFICIENT IFF Consider

with

Optimum of this program:

separating equilibrium impossible constraints satisfied for constraints satisfied for ' > .

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