Separating Equilibria, Positive Profits and Security Design

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