Belief Updating and Financial Decisions under Asymmetric Information

Abstract

This paper studies debt holders' belief updating and equity owners' financing decisions under asymmetric information during financial distress. This is done within a continuous-time framework, where the relevant state variable is assumed to follow an arithmetic Brownian motion (ABM). ABM can take negative values and has very realistic feature compared with geometric Brownian motion (GBM). Using Chapter 11 of U.S. Bankruptcy Code as a costly screening device, we can characterize which firm will choose private workouts (in the form of strategic debt service) and which will choose to file for the Chapter 11 Bankruptcy procedure (in the form of debt-equity swap) when the firm is in financial distress. Using arguments similar to equilibrium refinements, we give a clear picture of how the debt holders' beliefs about the firm's types are updated according to the state variable and the firm's default behavior, and describe optimal strategies of both parties under those beliefs.