A Liquidity-Based Model of Security Design
Peter DeMarzo and
Econometrica, 1999, vol. 67, issue 1, 65-100
The authors consider the problem of design and sale of a security backed by specified assets. Given access to higher-return investments, the issuer has an incentive to raise capital by securitizing part of these assets. At the time the security is issued, the issuer's or underwriter's private information regarding the payoff of the security may cause illiquidity in the form of a downward-sloping demand curve for the security. The authors characterize the optimal security design in several cases. They also demonstrate circumstances under which standard debt is optimal and show that the riskiness of the debt is increasing in the issuer's retention costs for assets.
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