Separating Equilibria, Positive Profits and Security Design

18 Pages Posted: 28 Sep 2020

See all articles by Dan Bernhardt

Dan Bernhardt

University of Illinois at Urbana-Champaign - Department of Economics

Kostas Koufopoulos

University of York

Giulio Trigilia

University of Rochester - Simon Business School

Date Written: August 11, 2020

Abstract

Classical security design papers equate competitive capital markets to securities being fairly-priced in expectation. We revisit the adverse selection setting of Nachman and Noe (1994), modeling capital-market competition as free entry of investors, and allowing firms to propose a price for the security issued, as is typical in private securities placements and bank lending. In addition to an equilibrium in which all firms pool on fairly-priced debt, we identify a continuum of separating equilibria in which high types issue under-priced debt, while low types issue more information-ally-sensitive securities, such as equity. We also uncover a continuum of pooling equilibria in which all types issue debt that is under-priced relative to the average firm type. Our model provides theoretical foundations for the pecking-order theory of external finance, and it reconciles positive profits for bank loans or privately-placed debt when lenders have no informational advantage.

Keywords: adverse selection, strictly positive profits, security design

Suggested Citation

Bernhardt, Dan and Koufopoulos, Kostas and Trigilia, Giulio, Separating Equilibria, Positive Profits and Security Design (August 11, 2020). Available at SSRN: https://ssrn.com/abstract=3671813 or http://dx.doi.org/10.2139/ssrn.3671813

Dan Bernhardt

University of Illinois at Urbana-Champaign - Department of Economics ( email )

1206 South Sixth Street
Champaign, IL 61820
United States
217-244-5708 (Phone)

Kostas Koufopoulos

University of York ( email )

Heslington
York, YO1 5DD
United Kingdom

Giulio Trigilia (Contact Author)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

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