Working Paper: NBER ID: w8746
Authors: Bhagwan Chowdhry; Mark Grinblatt; David Levine
Abstract: A model of security design based on the principle of information aggregation and alignment is used to show that (i) firms needing to finance their operations should issue different securities to different groups of investors in order to aggregate their disparate information and (ii) each security should be highly correlated (closely aligned) with the private information signal of the investor to whom it is marketed. This alignment reduces the adverse selection penalty paid by a firm with superior information. Adverse selection costs are often contingent on ex post publicly observable and contractible state variables such as exchange rates. In such cases, debt contracts are dominated by currency swaps. Moreover, optimal securities are derivative contracts that are contingent on state variables that influence adverse selection costs. This is because the netting of cash flows in these derivative contracts, in effect, alters the state-by-state seniority of different claims in a desirable way.
Keywords: information aggregation; security design; currency swaps
JEL Codes: G0; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Issuing distinct securities to domestic and foreign investors (F21) | better information aggregation (D83) |
| The design of securities that align closely with the private information of investors (D82) | reduced adverse selection costs (D82) |
| Optimal design of securities through currency swaps (G15) | minimizes adverse selection costs (D82) |