A security design model shows that multinational firms needing to finance their operations should issue different securities to investors in different countries in order to aggregate their disparate information about domestic and foreign cash flows. However, if the firm becomes bankrupt, investors may face uncertain costs of reorganizing assets in a foreign country and thus may value foreign assets at their average value. This penalizes superior firms with low reorganization costs. Such firms minimize the adverse selection penalty by designing securities that allocate all the cash flow in bankruptcy to investors for which the adverse selection costs are the smallest given the exchange rate. We show that this sharing rule can be implemented with currency swaps because these instruments allow the priorities of claims in bankruptcy to switch depending on the exchange rate.
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Cooper, Ian A & Mello, Antonio S, 1991.
" The Default Risk of Swaps,"
Journal of Finance,
American Finance Association, vol. 46(2), pages 597-620, June.
[Downloadable!] (restricted)
Franklin Allen, Douglas Gale, 1988.
"Optimal Security Design,"
Review of Financial Studies,
Oxford University Press for Society for Financial Studies, vol. 1(3), pages 229-263.
[Downloadable!] (restricted)
Other versions:
Boot, Arnoud W A & Thakor, Anjan V, 1993.
" Security Design,"
Journal of Finance,
American Finance Association, vol. 48(4), pages 1349-78, September.
[Downloadable!] (restricted)
Other versions:
Arnoud W A Boot & Anjan V Thakor, 1992.
"Security Design,"
CEPR Financial Markets Paper
0020, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 53--56 Great Sutton Street, London EC1V 0DG.
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