A Liquidity Based Model of Security Design

Download or read book A Liquidity Based Model of Security Design written by Peter M. DeMarzo and published by . This book was released on 1998 with total page pages. Available in PDF, EPUB and Kindle. Book excerpt: We consider the problem faced by an issuer who wishes to design and issue a security backed by some exogenously given assets. The issuer has access to higher return investments and so has an incentive to raise capital by securitizing these assets. Because the issuer has private information regarding the value of the assets at the time the security is issued, the security may be quot;illiquidquot;; that is, the issuer experiences a downward sloping demand curve for the security. The severity of this liquidity or quot;lemonsquot; problem depends upon the informational sensitivity of the issued security. Thus, the security design problem involves a tradeoff between the retention cost of holding any cash flows not included in the security design, and the liquidity cost of including the cash flows and making the security design more sensitive to the issuer's private information. We characterize the optimal security design in several cases. We show, for example, that indexing the security to market observables may be optimal. We also demonstrate circumstances in which standard debt is the optimal security. For this case, the debt is risky (i.e., has a positive probability of default). If the opportunity cost of the issuer is high enough, an equity claim on the underlying assets is optimal.