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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," 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. 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.
    2. repec:oup:rcorpf:v:4:y:2015:i:2:p:258-320. is not listed on IDEAS
    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.

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