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Optimal Security Design under Asymmetric Information and Profit Manipulation

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  • Kostas Koufopoulos
  • Roman Kozhan
  • Giulio Trigilia

Abstract

We consider a model of external financing in which entrepreneurs are privately informed about the quality of their projects and seek funds from competitive financiers. The literature restricts attention to monotonic, or “manipulation proof,” securities and finds that straight debt is the uniquely optimal contract. Monotonicity is commonly justified by the argument that it would endogenously arise if the entrepreneur can window dress the realized earnings before contract maturity. We explicitly characterize the optimal contracts when entrepreneurs engage in window dressing and/or output diversion and derive necessary and sufficient conditions for straight debt to be optimal. Contrary to conventional wisdom, debt is often suboptimal, and it is never uniquely optimal. Optimal contracts are nonmonotonic and induce profit manipulation in equilibrium. They can be implemented as performance-sensitive debt.Received: March 24, 2018; Editorial decision September 22, 2018 Editor: Uday Rajan

Suggested Citation

  • Kostas Koufopoulos & Roman Kozhan & Giulio Trigilia, 2019. "Optimal Security Design under Asymmetric Information and Profit Manipulation," The Review of Corporate Finance Studies, Society for Financial Studies, vol. 8(1), pages 146-173.
    • Handle: RePEc:oup:rcorpf:v:8:y:2019:i:1:p:146-173.
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    File URL: http://hdl.handle.net/10.1093/rcfs/cfy008
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    Cited by:

    1. Bernhardt, Dan & Koufopoulos, Kostas & Trigilia, Giulio, 2022. "Separating equilibria, underpricing and security design," Journal of Financial Economics, Elsevier, vol. 145(3), pages 788-801.

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