FINANCING UNDER ASYMMETRIC
INFORMATION
3th set of transparencies for ToCF
I.
INTRODUCTION
2 types of asymmetric information
investors / insiders
LEMONS
among investors
WINNER'S CURSE
Issue of claims may be motivated by
 insurance
 project financing,
 liquidity need
Asymmetry of information about
 value of assets in place,
 prospects attached to new investment,
 quality of collateral.
level
Two themes:(1)market breakdown
(2)costly signaling
riskiness
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Asymmetric information may account for a number of observations,
e.g.,:
negative stock price reaction to equity issuance (and smaller
reaction during booms),
 pecking-order hypothesis (issue low-information-intensity
securities first),
 market timing.
Asymmetric information predicts dissipative signals (besides lack of
financing), e.g.:






private placements,
limited diversification,
insufficient liquidity,
dividend distribution,
excess collateralization,
underpricing.
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II. MARKET BREAKDOWN
Privately-known-prospects model
•
•
•
•
Wealth A = 0, investment cost I.
Project succeeds (R) or fails (0).
Risk neutrality, LL, and zero interest rate in economy.
No moral hazard.
 Two borrower types
either pR > I > qR
or
(only good type is creditworthy)
pR > q R > I (both types are creditworthy)
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Symmetric information benchmark
•
• Not incentive compatible under asymmetric information.
Asymmetric information
 Cross subsidy:
 Overinvestment if bad borrower is not credit worthy.
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Measure of adverse selection
Counterpart of agency cost under moral hazard
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Extensions
(1) Market timing
Financing feasible when ( m +  ) R  I.
Adverse selection parameter smaller in booms ( large).
(2) Negative stock price reaction and going public decision
 Entrepreneur already has an existing project, with probability of
success p or q.
 Deepening investment would increase probability of success by 
Financing?
Good borrower can refuse to be financed. Hence pooling only if:
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Separating equilibrium (only bad borrower raises funds)
Negative stock price reaction upon issuance.
(3) Pecking-order hypothesis (Myers 1984)
(1) internal finance
Entrepreneur’s cash
Retained earnings
Information free?
“information
sensitivity”
(2) senior debt
(3) junior debt, convertible
(4) equity (“last resort”)
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 Payoff in case of failure is now RF > 0
Payoff in case of success is RS = RF + R.
 Max {good borrower's payoff}
s.t.
investors break even in expectation
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II. RESPONSES TO THE LEMONS PROBLEM
COSTLY COLLATERAL PLEDGING
PRIVATELY-KNOWN-PROSPECTS MODEL
No moral hazard
R
0
probability p
or
good
type
q
bad
type
Unlimited amount of collateral
Pledge
value  C
for investors
( < C )
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SYMMETRIC INFORMATION
Assume both types are creditworthy
they don’t pledge collateral.
Define
Allocation is not incentive compatible under AI.
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ASYMMETRIC INFORMATION
Separating allocation:
Both constraints must be binding
2 equations with 2 unknowns
and
Note:
safe payment
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DETERMINANTS OF COLLATERALIZATION
more collateral
p fixed,
more collateral
(agency problem )
Z: conditional on
Suppose (to the contrary) q small, then 
no need for collateral.
Positive covariation collateral-quality of borrower (NPV)
Z: MH story
reverse conclusion! Collateral boosts debt
capacity (MH: bad borrower defined as one who does not get
funded if he does not pledge collateral).
SEPARATING ALLOCATION UNIQUE EQUILIBRIUM IF
where
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IV LOW INFORMATION INTENSITY SECURITIES
General idea: good borrower tries to signal good prospects by
increasing the sensitivity of his own returns to the privy
information
reducing the investors’ claims’
sensitivity to this information.
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ARE LOW INFORMATION INTENSITY CLAIMS
ALWAYS DEBT CLAIMS?
No:
Outcome
L
M
H
“good type”
(higher expected returns)
“bad type”
OTHER SIGNALING DEVICES
 Suboptimal risk sharing Leland-Pyle 1977.
 Underpricing.
 ST financing,
 Monitoring (certification).
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APPENDIX 1
PRIVATELY-KNOWN-PRIVATE-BENEFIT MODEL WITH MORAL
HAZARD
Only borrower knows B
A=0
Hard to have separation:
bad type's utility  good type's
Model
 Outcome

Probability  : BL
Probability 1 : BH
BH > BL
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Assumptions
(Only "good type" gets financed under SI)
investors lose money
Only possibility:
Pooling. Define
by
no lending (breakdown)
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lending possible
BEST EQUILIBRIUM (for borrower) :
Cross-subsidies
where
"Reduced quality of lending" (relative to SI)
reduced NPV.
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APPENDIX 2
CONTRACT DESIGN BY AN INFORMED PARTY (ADVANCED)
2 types b probability 
~
b probability 1-
(generalizes to n types)
Contractual terms (possibly random) : c
Example: c = Rb
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Example : privately-known-private-benefit model
etc.
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ISSUANCE GAME
Borrower
offers
contract
Investors
accept / refuse
(If acceptance) borrower
exercises option
Remarks:
c tailored for b
tailored for
can be "no funding"
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DEFINITIONS
is
INCENTIVE COMPATIBLE IF
PROFITABLE TYPE-BY-TYPE IF
PROFITABLE IN EXPECTATION IF
Note: first and third necessary conditions for equilibrium behavior.
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Interim efficient allocation
= undominated in the set of allocations that are IC and profitable
in expectation.
Remark: profitable type-by-type is not "information intensive" (is
"safe", "belief free").
LOW INFORMATION INTENSITY OPTIMUM (LIIO) FOR TYPE
b:
Payoff
where c0 maximizes b’s utility in set of allocations
that are IC and profitable type-by-type:
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Similar definition for
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Lemma: LIIO
is incentive compatible.
Proof: Suppose, e.g., that
Consider solution
of LIIO program for b:
not LIIO for
after all.
Intuition: same constraints for both programs.
BORROWER CAN GUARANTEE HIMSELF HIS LIIO.
PROPOSITION
(1) Issuance game has unique PBE if LIIO interim efficient
(2) If LIIO interim inefficient, set of equilibrium payoffs = feasible
payoffs that dominate LIIO payoffs.
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SYMMETRIC INFORMATION ALLOCATION
solves
and similarly for
ASSUMPTION: (very weak): MONOTONICITY / TYPE:
(always satisfied if
not creditworthy, for example).
SEPARATING ALLOCATION
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must get at least this in equilibrium
PROPOSITION: under monotonicity assumption
LIIO= separating allocation
Proof:
LIIO
both types prefer (at least weakly) separating allocation to LIIO.
Type b can get the separating payoff: offers
IC by definition (note could offer
)
Type
can get
offers
which is safe for investors.
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PROPOSITION: under monotonicity assumption
SEPARATING ALLOCATION (LIIO) IS INTERIM EFFICIENT IFF
Consider
with
Optimum of this program:
separating equilibrium
impossible
constraints satisfied for 
constraints satisfied for ' > .
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