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Are adverse selection models of debt robust to changes in market structure?

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  • Vauhkonen, Jukka

    ()
    (Bank of Finland Research)

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    Abstract

    Many adverse selection models of standard one-period debt contracts are based on the following seemingly innocuous assumptions. First, entrepreneurs have private information about the quality of their return distributions. Second, return distributions are ordered by the monotone likelihood-ratio property. Third, financiers’ payoff functions are restricted to be monotonically non-decreasing in firm profits. Fourth, financial markets are competitive. We argue that debt is not an optimal contract in these models if there is only one (monopoly) financier rather than an infinite number of competitive financiers.

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    File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0328.pdf
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    Bibliographic Info

    Paper provided by Bank of Finland in its series Research Discussion Papers with number 28/2003.

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    Length: 34 pages
    Date of creation: 11 Nov 2003
    Date of revision:
    Handle: RePEc:hhs:bofrdp:2003_028

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    Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
    Web page: http://www.suomenpankki.fi/en/
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    Related research

    Keywords: security design; adverse selection; monotonic contracts; monotone likelihood ratio; first-order stochastic dominance;

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    1. Broecker, Thorsten, 1990. "Credit-Worthiness Tests and Interbank Competition," Econometrica, Econometric Society, vol. 58(2), pages 429-52, March.
    2. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
    3. Nachman, David C & Noe, Thomas H, 1994. "Optimal Design of Securities under Asymmetric Information," Review of Financial Studies, Society for Financial Studies, vol. 7(1), pages 1-44.
    4. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    5. Dowd, Kevin, 1992. "Optimal Financial Contracts," Oxford Economic Papers, Oxford University Press, vol. 44(4), pages 672-93, October.
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    7. Wang, Cheng & Williamson, Steve, 1998. "Debt Contracts and Financial Intermediation with Costly Screening," Staff General Research Papers 5086, Iowa State University, Department of Economics.
    8. Khalil, Fahad & Parigi, Bruno M, 1998. "Loan Size as a Commitment Device," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(1), pages 135-50, February.
    9. Myers, Stewart C. & Majluf, Nicholas S., 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Journal of Financial Economics, Elsevier, vol. 13(2), pages 187-221, June.
    10. Cheng Wang & Stephen D. Williamson, 1998. "Debt Contracts with Financial Intermediation with Costly Screening," Canadian Journal of Economics, Canadian Economics Association, vol. 31(3), pages 573-595, August.
    11. Mookherjee, Dilip & Png, Ivan, 1989. "Optimal Auditing, Insurance, and Redistribution," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 399-415, May.
    12. Innes, Robert, 1993. "Financial Contracting under Risk Neutrality, Limited Liability and Ex ante Asymmetric Information," Economica, London School of Economics and Political Science, vol. 60(237), pages 27-40, February.
    13. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
    14. Mas-Colell, Andreu & Whinston, Michael D. & Green, Jerry R., 1995. "Microeconomic Theory," OUP Catalogue, Oxford University Press, number 9780195102680, September.
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