Optimal Security Design under Asymmetric Information and Profit Manipulation

50 Pages Posted: 27 Jun 2014 Last revised: 28 Mar 2018

See all articles by Kostas Koufopoulos

Kostas Koufopoulos

University of Warwick - Finance Group

Roman Kozhan

University of Warwick - Warwick Business School

Giulio Trigilia

University of Rochester - Simon Business School

Multiple version iconThere are 2 versions of this paper

Date Written: March 1, 2018

Abstract

We consider a model of external financing in which privately informed entrepreneurs seek funds from competitive financiers. The literature restricts attention to monotonic securities and finds that straight debt is the uniquely optimal. Monotonicity is justified by the argument that it would arise endogenously if the entrepreneur can window dress the realized earnings. We explicitly characterize the optimal contracts when entrepreneurs can manipulate output, and derive necessary and sufficient conditions for debt to be optimal. Contrary to conventional wisdom, debt is often suboptimal and it is never uniquely optimal. Optimal contracts are non-monotonic and induce profit manipulation in equilibrium.

Keywords: Security design, financial innovation, capital structure, asymmetric information, venture capital

JEL Classification: D82; D86; G32; M40

Suggested Citation

Koufopoulos, Kostas and Kozhan, Roman and Trigilia, Giulio, Optimal Security Design under Asymmetric Information and Profit Manipulation (March 1, 2018). Available at SSRN: https://ssrn.com/abstract=2458980 or http://dx.doi.org/10.2139/ssrn.2458980

Kostas Koufopoulos

University of Warwick - Finance Group ( email )

Gibbet Hill Rd
Coventry, CV4 7AL
Great Britain

Roman Kozhan (Contact Author)

University of Warwick - Warwick Business School ( email )

Coventry CV4 7AL
United Kingdom

Giulio Trigilia

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

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