Securitization and Real Investment in Incomplete Markets

Abstract

We study the impact of financial innovations on real investment decisions within the framework of an incomplete market economy comprised of fi rms, investors, and an intermediary. The fi rms face unique investment opportunities that arise in their business operations and can be undertaken at given reservation prices. The cash flows thus generated are not spanned by the securities traded in the fi nancial market, and cannot be valued uniquely. The intermediary purchases claims against these cash flows, pools them together, and sells tranches of primary or secondary securities to the investors. We derive necessary and suffcient conditions under which projects are undertaken due to the intermediary's actions, and firms are amenable to the pool proposed by the intermediary, compared to the no-investment option or the option of forming alternative pools. We also determine the structure of the new securities created by the intermediary and identify how it exploits the arbitrage opportunities available in the market. Our results have implications for valuation of real investments, synergies among them, and their fi nancing mechanisms. We illustrate these implications using an example of inventory decisions under random demand.