1. FINANCING UNDER ASYMMETRIC INFORMATION 3th set of transparencies for ToCF

2. 2 INTRODUCTION 2 types of asymmetric information I. investors / insidersamong investors LEMONSWINNER'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

3. 3 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.

4. 4 MARKET BREAKDOWN II. 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) orpR > q R > I(both types are creditworthy)

5. 5 Symmetric information benchmark Cross subsidy: Not incentive compatible under asymmetric information. Asymmetric information Overinvestment if bad borrower is not credit worthy.

6. 6 Measure of adverse selection Counterpart of agency cost under moral hazard

7. 7 (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?

8. 8 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?

9. 9 Payoff in case of failure is now R F > 0 Payoff in case of success is R S = R F + R. Max {good borrower's payoff} s.t. investors break even in expectation

10. 10 Unlimited amount of collateral RESPONSES TO THE LEMONS PROBLEM II. COSTLY COLLATERAL PLEDGING PRIVATELY-KNOWN-PROSPECTS MODEL No moral hazard probability p or q good type bad type R 0 Pledge value  C (  < C ) for investors

11. 11 SYMMETRIC INFORMATION Assume both types are creditworthy they don’t pledge collateral. Allocation is not incentive compatible under AI. Define

12. 12 ASYMMETRIC INFORMATION Separating allocation: and Both constraints must be binding 2 equations with 2 unknowns Note: safe payment

13. 13 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).

14. 14 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 SECURITIES IV

15. 15 ARE LOW INFORMATION INTENSITY CLAIMS ALWAYS DEBT CLAIMS? No: LOutcomeMH “good type” (higher expected returns) “bad type” Suboptimal risk sharing Leland-Pyle 1977. Underpricing. ST financing, Monitoring (certification). OTHER SIGNALING DEVICES

16. 16 APPENDIX 1 Hard to have separation: PRIVATELY-KNOWN-PRIVATE-BENEFIT MODEL WITH MORAL HAZARD Only borrower knows B A=0 bad type's utility  good type's Model Outcome Probability  : B L Probability 1  : B H B H > B L

17. 17 Assumptions (Only "good type" gets financed under SI) Pooling. Define by investors lose money Only possibility: no lending (breakdown)

18. 18 lending possible BEST EQUILIBRIUM (for borrower) : Cross-subsidies where "Reduced quality of lending" (relative to SI) reduced NPV.

19. 19 (generalizes to n types) 2 types Contractual terms (possibly random) : c Example: c = R b bprobability  bprobability 1-  ~ APPENDIX 2 CONTRACT DESIGN BY AN INFORMED PARTY (ADVANCED)

20. 20 etc. Example : privately-known-private-benefit model

21. 21 c tailored for b tailored for ISSUANCE GAME Borrower offers contract Investors accept / refuse (If acceptance) borrower exercises option Remarks: can be "no funding"

22. 22 DEFINITIONS Note: first and third necessary conditions for equilibrium behavior. is INCENTIVE COMPATIBLE IF PROFITABLE TYPE-BY-TYPE IF PROFITABLE IN EXPECTATION IF

23. 23 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 c 0 maximizes b’s utility in set of allocations that are IC and profitable type-by-type:

24. 24 Similar definition for

25. 25 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.

26. 26 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

27. 27 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

28. 28 with PROPOSITION: under monotonicity assumption Optimum of this program: SEPARATING ALLOCATION (LIIO) IS INTERIM EFFICIENT IFF Consider constraints satisfied for  separating equilibrium impossible constraints satisfied for  ' > .