Efficient Security Design: Theory and Application

Abstract

This paper develops a theory of efficient design of financial securities when different parties in a corporate relationship contract under multilateral asymmetric information. A methodology for analyzing general financial contracting games is proposed. Rigorous, game-theoretic criteria such as incentive-constrained ex ante, interim, and ex post efficiency are used to evaluate the welfare properties of different security designs. The threat points of the various parties are shown to hold the key to overall contracting efficiency, and financial securities become relevant for efficiency only through the threat points. In order to motivate the issue, an application involving security design in joint-ventures is presented first. The theory of efficient security design is presented next, in the context of a large class of general financial contracting games involving investments and multilateral asymmetric information. It is shown that under weak conditions, all securities that are efficient from an ex ante and interim viewpoint involve a quasi-debt feature. Moreover, while a quasi-debt structure improves efficiency in firms with high capital intensity, it has no welfare advantage in firms with little physical capital. Importantly, the results are robust in the sense that they hold whether the agents are risk-neutral or risk-averse, under any distributional assumptions, and regardless of the exact extensive-form specification of the contracting game.