Security Design with Ratings

Abstract

We investigate the effect of public information, such as ratings, on the security design problem of a privately informed issuer. We show that the presence of ratings has important implications for both the form of security designed and the amount of inefficient retention. The model predicts that issuers will design informationally sensitive securities (i.e., levered equity) when ratings are sufficiently informative relative to the gains from trade. Otherwise, issuers opt for a standard debt contract. In either case, informative ratings increase market liquidity by decreasing the reliance on inefficient retention to convey high quality, and perhaps counterintuitively, decrease price informativeness.

Keywords: Security Design, Liquidity, Private Information, Credit Ratings, Public Disclosure

JEL Classification: G23, G32, D82