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Rational Beliefs and Security Design

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  • Garmaise, Mark

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 (1994). 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. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

Suggested Citation

  • Garmaise, Mark, 2001. "Rational Beliefs and Security Design," The Review of Financial Studies, Society for Financial Studies, vol. 14(4), pages 1183-1213.
    • Handle: RePEc:oup:rfinst:v:14:y:2001:i:4:p:1183-1213
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    Cited by:

    1. Onur Bayar & Thomas J. Chemmanur & Mark H. Liu, 2015. "A Theory of Capital Structure, Price Impact, and Long-Run Stock Returns under Heterogeneous Beliefs," The Review of Corporate Finance Studies, Society for Financial Studies, vol. 4(2), pages 258-320.
    2. Agapova, Anna & Volkov, Nikanor, 2019. "Guidance on strategic information: Investor-management disagreement and firm intrinsic value," Journal of Banking & Finance, Elsevier, vol. 108(C).
    3. Bayar, Onur & Chemmanur, Thomas J. & Liu, Mark H., 2011. "A theory of equity carve-outs and negative stub values under heterogeneous beliefs," Journal of Financial Economics, Elsevier, vol. 100(3), pages 616-638, June.
    4. Li, Qi, 2022. "Security design without verifiable retention," Journal of Economic Theory, Elsevier, vol. 200(C).
    5. Huang, Sheng & Maharjan, Johan & Thakor, Anjan V., 2020. "Disagreement-induced CEO turnover," Journal of Financial Intermediation, Elsevier, vol. 43(C).
    6. Juan M. Ortner & Martin C. Schmalz, 2018. "Disagreement and Optimal Security Design," CESifo Working Paper Series 6906, CESifo.
    7. Arnoud W. A. Boot & Radhakrishnan Gopalan & Anjan V. Thakor, 2008. "Market Liquidity, Investor Participation, and Managerial Autonomy: Why Do Firms Go Private?," Journal of Finance, American Finance Association, vol. 63(4), pages 2013-2059, August.
    8. Zhiguo He & Wei Xiong, 2010. "Financing Speculative Booms," Levine's Working Paper Archive 661465000000000327, David K. Levine.
    9. Schmalz, Martin & Ortner, Juan, 2018. "Disagreement and Security Design," CEPR Discussion Papers 12596, C.E.P.R. Discussion Papers.

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