A liquidity-based model of security design

We consider the problem of the design and sale of a security backed by spec ified assets. Given access to higher-return investments, the issuer has an incentive to raise capital by securitizing part of these assets. At the tim e the security is issued, the issuer's or underwriter's private information regarding the payoff of the security may cause illiquidity, in the form of a downward-sloping demand curve for the security. The severity of this ill iquidity depends upon the sensitivity of the value of the issued security t o the issuer's private information. Thus, the security-design problem invol ves a tradeoff between the retention cost of holding cash flows not include d in the security design, and the liquidity cost of including the cash flow s and making the security design more sensitive to the issuer's private inf ormation. We characterize the optimal security design in several cases. We also demonstrate circumstances under which standard debt is optimal and sho w that the riskiness of the debt is increasing in the issuer's retention co sts for assets.