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					FINANCING UNDER ASYMMETRIC
INFORMATION

3th set of transparencies for ToCF
I.     INTRODUCTION
                2 types of asymmetric information
               investors / insiders    among investors
                   LEMONS              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
            (2)costly signaling
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.
                                                                   3
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)

                                                                4
Symmetric information benchmark
 •
 • Not incentive compatible under asymmetric information.

Asymmetric information




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




                                                            5
Measure of adverse selection




Counterpart of agency cost under moral hazard




                                                6
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:

                                                                  7
Separating equilibrium (only bad borrower raises funds)
               Negative stock price reaction upon issuance.

(3) Pecking-order hypothesis (Myers 1984)

                   (1) internal finance           Entrepreneur’s cash
                                                  Retained earnings

                                                  Information free?

“information       (2) senior debt
sensitivity”
                   (3) junior debt, convertible

                   (4) equity (“last resort”)




                                                                        8
 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




                                              9
II. RESPONSES TO THE LEMONS PROBLEM

 COSTLY COLLATERAL PLEDGING
 PRIVATELY-KNOWN-PROSPECTS MODEL
   No moral hazard


        R     probability p or      q
        0
                          good       bad
                          type       type


   Unlimited amount of collateral
                     Pledge      value  C       ( < C )
                                 for investors
                                                            10
SYMMETRIC INFORMATION
Assume both types are creditworthy      they don’t pledge collateral.



Define




Allocation is not incentive compatible under AI.




                                                                11
                  ASYMMETRIC INFORMATION
Separating allocation:




Both constraints must be binding     2 equations with 2 unknowns




and




Note:                              safe payment                12
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
                                                                 13
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.




                                                                   14
              ARE LOW INFORMATION INTENSITY CLAIMS
                              ALWAYS DEBT CLAIMS?

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

      “bad type”


 OTHER SIGNALING DEVICES
  Suboptimal risk sharing Leland-Pyle 1977.
  Underpricing.
  ST financing,
  Monitoring (certification).
                                                     15
                             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
                           BH > BL
    Probability 1 : BH
                                                    16
Assumptions



    (Only "good type" gets financed under SI)




      investors lose money
 Only possibility:

  Pooling. Define    by



                                                17
       no lending (breakdown)
      lending possible
BEST EQUILIBRIUM (for borrower) :

 Cross-subsidies
                   where
 "Reduced quality of lending" (relative to SI)

                         reduced NPV.




                                                 18
                            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




                                              19
Example : privately-known-private-benefit model




            etc.




                                                  20
                        ISSUANCE GAME


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



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




                                                            21
                            DEFINITIONS

     is



INCENTIVE COMPATIBLE IF



PROFITABLE TYPE-BY-TYPE IF


PROFITABLE IN EXPECTATION IF


Note: first and third necessary conditions for equilibrium behavior.


                                                                   22
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:




                                                                   23
Similar definition for




                         24
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




                                                               26
                       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.



                                                                   27
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 ' > .    28

				
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