Familiarity Bias and Optimal Security Design in International Markets

An extensive literature has found that individuals favor investments that they are more familiar with and are geographically proximate. Familiarity bias implies that foreign investors may perceive lower expected payoff and/or higher risk for domestic firm’s asset payoffs. This paper explores how a firm issues different securities across borders in segmented international financial markets under the assumption of familiarity bias. We investigate optimal mix of securities in domestic and foreign markets considering four types of securities: (i) linear securities, (ii) quadratic securities, (iii) warrants, and (iv) general securities which maximize the proceeds. The consideration of linear securities leads to an analysis of dual listing issues and we show that the price traded in the foreign market will be lower. Analysis of the quadratic securities demonstrates that it is optimal to issue convex quadratic security for foreign investors and concave quadratic securities for domestic investors. Moreover, we consider optimal security design which further confirms that the optimal security for foreign investors tends to be more convex than the optimal security for domestic investors. In addition, we find that the proceeds obtained using convertible securities can be higher than that of the quadratic securities and be very close to that of the optimal securities. We also show that issuing non-linear securities can result in proceeds larger than any investor’s expected value of the firm.