Asymmetric Information and Security Design under Knightian Uncertainty
88 Pages Posted: 18 Jan 2018 Last revised: 25 Oct 2023
Date Written: February 14, 2020
Abstract
A privately informed issuer raises project financing from an uninformed investor through a security sale. The investor faces Knightian uncertainty and evaluates each security by the worst-case cash flow distribution that justifies the security offering. In the unique equilibrium, both standard outside equity and standard debt are issued by different issuer types, providing a common foundation for two widespread financial contracts. Equity is effective in signaling the project’s positive NPV and prevalent under high uncertainty. Debt better exploits the issuer’s informational advantage when the upside is likely and usually arises when the investor knows that the NPV is positive.
Keywords: robustness, security design, asymmetric information, Knightian uncertainty, signaling
JEL Classification: D81, D82, D86, G32
Suggested Citation: Suggested Citation