Security Design in Production Economy with Flexible Information Acquisition

Abstract

This paper looks into security design in a production economy with a new informational friction. It highlights the investor as an expert, who may acquire costly information on the market prospect of the entrepreneur’s project and then screen it through nancing decisions. Thus, real production depends on information production, while these two are separated, which constructs a friction. Debt is optimal when the dependence of real production on information production is weak and thus the friction is not severe, and convertible preferred stock is optimal when the dependence is strong and thus the friction is severe. Such a dichotomy is unied under a new interaction between the payo structures of securities and the exible incentives to screen regarding attention allocation. Both the optimal securities and their correspondences to economic environments t in line with empirical evidence. A new approach, exible information acquisition, characterizes information sensitiveness of securities and attention allocation of investors in a state contingent way, which enables us to work with arbitrary securities on continuous states without distributional assumptions and delivers sharper predictions.