Micro Theory Seminar: Andrey Malenko (University of Michigan)

An issuer, privately informed about the distribution of the project’s cash flows, raises financing from an uninformed investor through a security sale. The investor faces Knightian uncertainty about the distribution of cash flows and evaluates each security by the worst-case distribution at which she could justify it being offered by the issuer. We characterize the generically unique equilibrium of this non-Bayesian signaling game. Both standard outside equity and risky debt are issued by different issuer types in equilibrium, providing a common foundation for two most widespread financial contracts. The equilibrium security depends on the degree of uncertainty and the nature of private information. If private information concerns a new project and uncertainty is sufficiently high, outside equity prevails in equilibrium. When uncertainty is sufficiently small, the equilibrium typically features risky debt and never outside equity. If private information concerns assets in place, equity is never issued, irrespective of the level of uncertainty, and the equilibrium security is (usually) risky debt.