Asymmetric Information and Security Design under Knightian Uncertainty (with with Andrey Malenko)

Abstract:
We study optimal security design by an informed issuer when the investor faces Knightian uncertainty about the distribution of cash flows from the project and demands robustness: she evaluates each security by the worst-case rationalizable model. In equilibrium, the security offer affects the investor’s assessment of its value through both the structure of payoffs from the security and signaling of the issuer’s private information. When uncertainty is sufficiently high, standard equity arises as the unique equilibrium security. When uncertainty is sufficiently small, the equilibrium typically features risky debt. In the intermediate case, both risky debt and standard equity arise in equilibrium. When private information is about assets in place of the issuer rather than a new project, standard equity is no longer issued in equilibrium, irrespective of the level of uncertainty, and the equilibrium (usually) features risky debt.