Asymmetric Information and Security Design under Knightian Uncertainty∗

We study optimal security design by an informed issuer when the investor faces Knightian uncertainty about the distribution of cash flows and demands robustness: she evaluates each security by the worst-case distribution at which she could justify it being offered by the issuer. First, we show that both standard outside equity and standard risky debt arise as equilibrium securities. Thus, the model provides a common foundation for two most widespread financial contracts based on one simple market imperfection, information asymmetry. Second, we show that the equilibrium security differs depending on the degree of uncertainty and on whether private information concerns assets in place or the new project. If private information concerns the new project and uncertainty is sufficiently high, standard equity arises as the unique equilibrium security. When uncertainty is sufficiently small, the equilibrium typically features risky debt. In the intermediate case, both risky debt and standard equity arise in equilibrium. In contrast, if private information concerns assets in place, standard equity is never issued in equilibrium, irrespective of the level of uncertainty, and the equilibrium security is (usually) risky debt. ∗We thank Hengjie Ai, Luigi Guiso, Leonid Kogan, Juan Ortner, Jonathan Parker, Christine Parlour, Francesco Sangiorgi, Muhamet Yildiz, and participants at the SFS Cavalcade, UBC Winter Finance Conference, ESSFM (Gerzensee), and MIT theory lunch for helpful comments. †MIT Sloan School of Management. Email: [email protected]. ‡Einaudi Institute for Economics and Finance. Email: [email protected]. 1 CBA Events Room Thursday, September 7th, 2017 11:00 am