Rational Beliefs and Security Design

Posted: 29 Feb 2008

See all articles by Mark J. Garmaise

Mark J. Garmaise

University of California, Los Angeles (UCLA) - Anderson School of Management

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Date Written: October 2001

Abstract

This article studies the security-design problem of a cash-constrained firm facing investors with diverse beliefs. Investor "rational beliefs" are modeled as varying and yet rational in the sense of Kurz (1994a). With two investors, optimal designs are similar under rational beliefs and rational expectations. With many investors, however, optimal securities under rational beliefs maximize investor differences of opinion, while under rational expectations optimal designs minimize disagreements. We demonstrate that the common practice of issuing multiple securities backed by a single asset is optimal under rational beliefs but not under rational expectations. Researching market beliefs can create substantial value for firms.

Suggested Citation

Garmaise, Mark J., Rational Beliefs and Security Design (October 2001). Review of Financial Studies, Vol. 14, Issue 4, pp. 1183-1213, 2001, Available at SSRN: https://ssrn.com/abstract=900663

Mark J. Garmaise (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

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