Robust Security Design

44 Pages Posted: 14 Jan 2017 Last revised: 13 Dec 2018

See all articles by Seokwoo Lee

Seokwoo Lee

University of Michigan at Ann Arbor, Stephen M. Ross School of Business, Finance; George Mason University, School of Business - Finance Area

Uday Rajan

Stephen M. Ross School of Business, University of Michigan

Date Written: December 8, 2018

Abstract

We consider the optimal contract between an entrepreneur and investors in a moral hazard model when both parties have limited liability, are risk-neutral toward cash flow risk, and are ambiguity-averse. In the static setting, the first-best security is either convertible debt or levered equity. The optimal second-best security has an equity-like component in high cash flow states. Finally, if the two parties can renegotiate the contract after acquiring more information, the initial contract is risky debt. It is later renegotiated to a security with an equity component, and the conversion factor depends on the information acquired in the interim.

Keywords: Optimal Security Design, Robustness, Moral Hazard, Ambiguity aversion, limited liability, optimal contract

JEL Classification: G32, D82, D86

Suggested Citation

Lee, Seokwoo and Rajan, Uday, Robust Security Design (December 8, 2018). Ross School of Business Paper No. 1338. Available at SSRN: https://ssrn.com/abstract=2898462 or http://dx.doi.org/10.2139/ssrn.2898462

Seokwoo Lee (Contact Author)

University of Michigan at Ann Arbor, Stephen M. Ross School of Business, Finance ( email )

701 Tappan Street
Ann Arbor, MI 48109-1234
United States

George Mason University, School of Business - Finance Area ( email )

Fairfax, VA 22030
United States
7039935163 (Phone)

HOME PAGE: http://www-personal.umich.edu/~seokwoo

Uday Rajan

Stephen M. Ross School of Business, University of Michigan ( email )

701 Tappan Street
Ann Arbor, MI 48109
United States
734-764-2310 (Phone)

HOME PAGE: http://webuser.bus.umich.edu/urajan

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