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Optimal Security Design for Risk-Averse Investors

Alex Gershkov (alexg@huji.ac.il), Benny Moldovanu (mold@uni-bonn.de), Philipp Strack (philipp.strack@yale.edu) and Mengxi Zhang (mzhang@uni-bonn.de)
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Alex Gershkov: Department of Economics and the Federmann Center for the Study of Rationality, The Hebrew University of Jerusalem & University of Surrey
Benny Moldovanu: Department of Economics, University of Bonn
Philipp Strack: Department of Economics, Yale University
Mengxi Zhang: Department of Economics, University of Bonn

No 325, ECONtribute Discussion Papers Series from University of Bonn and University of Cologne, Germany

Abstract: We use the tools of mechanism design, combined with the theory of risk measures, to analyze a model where a cash constrained owner of an asset with stochastic returns raises capital from a population of investors that differ in their risk aversion and budget constraints. The distribution of the asset's cash flow is assumed here to be common-knowledge: no agent has private information about it. The issuer partitions and sells the asset's cash flow into several asset-backed securities, one for each type of investor. The optimal partition conforms to the commonly observed practice of tranching (e.g., senior debt, junior debt and equity) where senior claims are paid before the subordinate ones. The holders of more senior/junior tranches are determined by the relative risk appetites of the different types of investors and of the issuer, with the more risk-averse agents holding the more senior tranches. Tranching endogenously arises here in an optimal mechanism because of simple economic forces: the differences in risk appetites among agents, and in the budget constraints they face.

Keywords: Security Design; Risk Aversion; Tranching; Pooling (search for similar items in EconPapers)
JEL-codes: D82 G00 (search for similar items in EconPapers)
Pages: 57 pages
Date: 2024-07
New Economics Papers: this item is included in nep-des, nep-rmg and nep-upt
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Persistent link: https://EconPapers.repec.org/RePEc:ajk:ajkdps:325

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