OPTIMAL-DESIGN OF SECURITIES UNDER ASYMMETRIC INFORMATION

A firm must decide what security to sell to raise external capital to finance a profitable investment opportunity. There is ex ante asymmetr y of information regarding the probability distribution of cash flow g enerated by the investment. In this setting we derive necessary and su fficient conditions for a security to be optimal (uniquely optimal), t hat is, for pooling at this security to be an (the unique) equilibrium outcome. Using these conditions we show that the debt contract is (un iquely) optimal if and only if cash flows are ordered by (strict) cond itional stochastic dominance. Finally, we derive an equivalence relati onship between optimal security designs and designs that minimize misp ricing.