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Information Aggregation, Security Design and Currency Swaps

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  • Bhagwan Chowdhry
  • Mark Grinblatt
  • David Levine

Abstract

A model of security design based on the principle of information aggregation and alignment is used to show that (i) firms needing to finance their operations should issue different securities to different groups of investors in order to aggregate their disparate information and (ii) each security should be highly correlated (closely aligned) with the private information signal of the investor to whom it is marketed. This alignment reduces the adverse selection penalty paid by a firm with superior information. Adverse selection costs are often contingent on ex post publicly observable and contractible state variables such as exchange rates. In such cases, debt contracts are dominated by currency swaps. Moreover, optimal securities are derivative contracts that are contingent on state variables that influence adverse selection costs. This is because the netting of cash flows in these derivative contracts, in effect, alters the state-by-state seniority of different claims in a desirable way.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 8746.

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Date of creation: Jan 2002
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Publication status: published as Chowdhry, Bhagwan, Mark Grinblatt and David Levine. "Information Aggregation, Security Design, And Currency Swaps," Journal of Political Economy, 2002, v110(3,Jun), 609-633.
Handle: RePEc:nbr:nberwo:8746

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Cited by:
  1. Salvatore Cantale & Dmitry Lukin, 2012. "Multiple-Project Financing with Informed Trading," Journal of Entrepreneurial Finance, Pepperdine University, Graziadio School of Business and Management, vol. 16(1), pages 1-28, Spring.
  2. Gersbach, Hans & Uhlig, Harald, 2006. "Debt contracts and collapse as competition phenomena," Journal of Financial Intermediation, Elsevier, vol. 15(4), pages 556-574, October.
  3. Goswami, Gautam & Nam, Jouahn & Shrikhande, Milind M., 2004. "Why do global firms use currency swaps?: Theory and evidence," Journal of Multinational Financial Management, Elsevier, vol. 14(4-5), pages 315-334.

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