Asymmetric Information and Security Design under Knightian Uncertainty

63 Pages Posted: 18 Jan 2018 Last revised: 15 Feb 2020

See all articles by Andrey Malenko

Andrey Malenko

University of Michigan, Stephen M. Ross School of Business; Centre for Economic Policy Research (CEPR)

Anton Tsoy

University of Toronto - Department of Economics

Date Written: February 14, 2020

Abstract

An issuer, privately informed about the distribution of the project's cash flows, raises financing from an uninformed investor through a security sale. The investor faces Knightian uncertainty about the distribution of cash flows and evaluates each security by the worst-case distribution at which she could justify it being offered by the issuer. We characterize the generically unique equilibrium of this non-Bayesian signaling game. Both standard outside equity and risky debt are issued by different issuer types in equilibrium, providing a common foundation for two most widespread financial contracts. The equilibrium security depends on the degree of uncertainty and the nature of private information. If private information concerns a new project and uncertainty is sufficiently high, outside equity prevails in equilibrium. When uncertainty is sufficiently small, the equilibrium typically features risky debt and never outside equity. If private information concerns assets in place, equity is never issued, irrespective of the level of uncertainty, and the equilibrium security is (usually) risky debt.

Keywords: robustness, security design, asymmetric information, Knightian uncertainty, signaling

JEL Classification: D81, D82, D86, G32

Suggested Citation

Malenko, Andrey and Tsoy, Anton, Asymmetric Information and Security Design under Knightian Uncertainty (February 14, 2020). Available at SSRN: https://ssrn.com/abstract=3100285 or http://dx.doi.org/10.2139/ssrn.3100285

Andrey Malenko

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

701 Tappan Street
Ann Arbor, MI MI 48109
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Anton Tsoy (Contact Author)

University of Toronto - Department of Economics ( email )

150 St. George Street
Toronto, Ontario M5S3G7
Canada

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