Optimal Security Design Research Articles

Dynamic Asset-Backed Security Design

Abstract Borrowers obtain liquidity by issuing securities backed by the current period payoff and resale price of a long-lived collateral asset, and they are privately informed about the payoff distribution. Asset price can be self-fulfilling: a higher asset price lowers adverse selection and allows borrowers to raise greater funding, which makes the asset more valuable, leading to multiple equilibria. Optimal security design eliminates multiple equilibria, improves welfare, and can be implemented as a repo contract. Persistent adverse selection lowers debt funding, generates volatility in asset prices, and exacerbates credit crunches. The theory demonstrates the role of asset-backed securities on stability of market-based financial systems.

Optimal Security Design for Risk-Averse Investors

Optimal Security Design for Risk-Averse Investors

Backers: Consumers or Investors? Crowdfunding vs. Traditional Financing as an Optimal Security Design Problem

Backers: Consumers or Investors? Crowdfunding vs. Traditional Financing as an Optimal Security Design Problem

Security design without verifiable retention

This paper studies security design with adverse selection when verifiable retention is impossible due to market segmentation and price opacity across market segments. Rather than signaling through retention, sellers in the model signal quality through posted prices, which is feasible because the posted price affects buyers' search behavior and the equilibrium probability of selling. The optimal security design, in this case, is to break up the cash flow of an asset into several debt securities of increasing seniority. The size of senior relative to subordinated debts is affected by the equilibrium markup. Search frictions, as determinants of the markup, shape the endogenous creation of financial securities.

Optimal Security Design under Asymmetric Information and Profit Manipulation

We consider a model of external financing under ex ante asymmetric information and profit manipulation (non verifability). Contrary to conventional wisdom, the optimal contract is not standard debt, and it is not monotonic. Instead, it resembles a contingent convertible (CoCo) bond. In particular: (i) if the profit manipulation and/or adverse selection are not severe, there exists a unique separating equilibrium in CoCos; (ii) in the intermediate region, if the distribution of earnings is unbounded above there exists a unique pooling equilibrium in CoCos, otherwise debt might be issued but it is never the unique equilibrium; (iii) finally, if profit manipulation is severe, there is no financing These findings suggest that the standard monotonicity constraint exogenously imposed in the security design literature must be reconsidered. Crucially, profit manipulation is part of the optimal contract, and non-monotonic, convertible securities mitigate the asymmetric information problem. We discuss milestone payments in venture capital as an application.

Dynamic Liquidity-Based Security Design

Borrowers obtain liquidity by issuing securities backed by current period payoff and resale price of a long-lived collateral asset. They are privately informed about the payoff distribution. Asset price can be self-fulfilling: higher asset price lowers adverse selection, allows borrowers to raise more funding which makes the asset more valuable, leading to multiple equilibria. Optimal security design eliminates multiple equilibria, improves welfare, and can be implemented as a repo contract. Persistence in adverse selection lowers debt funding, generates volatility in asset price, and exacerbates credit crunch. The theory demonstrates the role of asset-backed securities on the stability of market-based financial systems.

Disagreement and Optimal Security Design

We study optimal security design when the issuer and market participants agree to disagree about the characteristics of the asset to be securitized. We show that pooling assets can be optimal because it mitigates the effects of disagreement between issuer and investors, whereas tranching a cash-flow stream allows the issuer to exploit disagreement between investors. Interestingly, pooling and tranching can be complements. The optimality of debt with or without call provisions can be derived as a special case. In a model with multiple financing rounds, convertible securities naturally emerge to finance highly skewed ventures.

Optimal dynamic contracts with moral hazard and costly monitoring

We introduce a tractable dynamic monitoring technology into a continuous-time moral-hazard problem and study the optimal long-term contract between principal and agent. Monitoring adds value by allowing the principal to reduce the intensity of performance-based incentives, reducing the likelihood of costly termination. We present a novel characterization of optimal dynamic incentive provision when performance-based incentives may decline continuously to zero. Termination happens in equilibrium only if its costs are relatively low. In general, the intensity of both monitoring and performance-based compensation can be non-monotonic functions of the quality of past performance. Our results can also help explain puzzling empirical findings on the relationship between performance history and future pay-performance sensitivity and on the linkage between termination, performance, and monitoring. We also discuss implications of our model for optimal security design and endogenous financing constraints.

Optimal Financing and Disclosure

How does a firm’s disclosure policy depend on its choice of financing? In this paper, I study a firm that finances a project with uncertain payoffs and jointly chooses its disclosure policy and the security issued. I show that it is optimal to truthfully reveal whether the project’s payoffs are above a threshold. This class of threshold policies is optimal for any prior belief, for any security, and any increasing utility function of the entrepreneur. I characterize how the optimal disclosure threshold depends on the underlying security, the prior, and the cost of investment. The optimal security design is indeterminate despite the presence of adverse selection. Among others, the optimum can be implemented with equity, debt, and options.

Secondary Market Liquidity and Security Design: Theory and Evidence from ABS Markets

We develop and empirically test a theory of optimal security design under adverse selection accounting for strategic trading by uninformed investors who will liquidate a security in secondary markets only if their idiosyncratic carrying costs exceed the security's expected trading loss. Such investors demand primary market discounts equaling expected carrying costs borne plus trading losses incurred. Issuers minimize the total illiquidity discount by splitting cash-flow into tranched debt claims with liquidity predicted to increase with seniority, while the optimal number of tranches increases with underlying cash-flow risk. Empirical tests confirm our model predictions.

Secondary Market Liquidity and Security Design: Theory and Evidence from ABS Markets

We develop and empirically test a theory of optimal security design under adverse selection accounting for strategic trading by uninformed investors who will liquidate a security in secondary markets only if their idiosyncratic carrying costs exceed the security's expected trading loss. Such investors demand primary market discounts equaling expected carrying costs borne plus trading losses incurred. Issuers minimize the total illiquidity discount by splitting cash-flow into tranched debt claims with liquidity predicted to increase with seniority, while the optimal number of tranches increases with underlying cash-flow risk. Empirical tests confirm our model predictions.

Optimal Security Design with Disagreement

We study optimal security design when issuer and market participants disagree about the characteristics of the underlying asset. We show that pooling and tranching assets can be preferable to selling optimal securities backed by individual assets: pooling mitigates belief disagreement between issuer and investors, and tranching allows the issuer to exploit belief disagreement among investors. Interestingly, differences in beliefs can make pooling and tranching complements. Pooling and tranching can be optimal even when the number of securities in the pool is small, and remain optimal even when the issuer sells all tranches, including the most junior ones.

‘If the Facts Don't Fit the Theory … ’: The Security Design Puzzle in Venture Finance

When confronting theory with evidence, divergent results surface with reference to the optimal securities that should be adopted in venture capital (VC) finance. The vast majority of the theoretical models on VC consistently predict that convertible securities, especially in the form of convertible preferred stocks, represent the optimal form of finance. While the theoretical literature seems to be supported by empirical studies in the US, the evidence outside the US shows the opposite results. Puzzling patterns emerge, especially when comparing the evidence from the US, Canada and Europe, and an intensive academic debate is under way. The evidence becomes even more challenging when considering the contrasting financing behaviour of US venture capitalists (VCs) investing in Canada. It has been documented that US VCs investing in Canada adopt a wide range of securities other than convertible stocks. If convertible securities truly represent the optimal form of VC finance, why would US VCs use different types of securities when investing in Canada? At present, researchers are still arguing about which factors would have the most significant impact on explaining the different financing behaviour of VCs around the world. The purpose of this paper is to shed some light on the ongoing international debate on the optimal security design and contracting behaviour in venture finance. With this review, the authors intend to contribute to the VC literature by identifying current trends, explanations and determinants underlying the puzzling empirical evidence on the financing structure adopted by VCs around the world.

Complexity and Loan Performance: Evidence from the Securitization of Commercial Mortgages

Between 2001 and 2007, the complexity of commercial mortgage-backed securities (CMBS) increased substantially. The median size of commercial mortgage loan pools tripled and the median number of AAA-rated tranches doubled. I examine whether deal complexity is related to loan performance by analyzing a sample of approximately 40,000 commercial mortgage loans from 334 CMBS deals. I find that loan performance is worse for loans in more complex securitizations. However, neither the price of a deal’s securities nor a deal’s risk retention reflected that complexity correlates with lower loan quality. These findings present a challenge for theories of optimal security design.

Optimal Security Design under Asymmetric Information and Profit Manipulation

We consider a model of external financing under ex ante asymmetric information and profit manipulation (non verifability). Contrary to conventional wisdom, the optimal contract is not standard debt, and it is not monotonic. Instead, it resembles a contingent convertible (CoCo) bond. In particular: (i) if the profit manipulation and/or adverse selection are not severe, there exists a unique separating equilibrium in CoCos; (ii) in the intermediate region, if the distribution of earnings is unbounded above there exists a unique pooling equilibrium in CoCos, otherwise debt might be issued but it is never the unique equilibrium; (iii) finally, if profit manipulation is severe, there is no financing. These findings suggest that the standard monotonicity constraint exogenously imposed in the security design literature must be reconsidered. Crucially, profit manipulation is part of the optimal contract, and non-monotonic, convertible securities mitigate the asymmetric information problem. We discuss milestone payments in venture capital as an application.

Deal Complexity, Loan Performance, and the Pricing of Commercial Mortgage Backed Securities

Between 2001 and 2007, the complexity of commercial mortgage-backed securities (CMBS) increased substantially. The median size of commercial mortgage loan pools tripled and the median number of AAA-rated tranches doubled. I examine whether deal complexity is related to loan performance by analyzing a sample of approximately 40,000 commercial mortgage loans from 334 CMBS deals. I find that loan performance is worse for loans in more complex securitizations. However, neither the price of a deal’s securities nor a deal’s risk retention reflected that complexity correlates with lower loan quality. These findings present a challenge for theories of optimal security design.

Preserving 'Debt Capacity' or 'Equity Capacity': A Dynamic Theory of Security Design Under Asymmetric Information

In a dynamic model of optimal security design, we show when firms should preserve equity capacity through choosing high target leverage or debt capacity through choosing low target leverage. Thereby, firms reduce a problem of underinvestment or overinvestment when they must raise future financing under asymmetric information. Which problem arises depends on whether additional financing is raised at competitive terms or whether there is a lock-in with initial investors. Firms’ initial (or target) capital structure matters as it affects the option of both insiders and outside investors. Our theory also entails implications for start-up and venture capital financing.

Longevity risk, retirement savings, and financial innovation

Over the last couple of decades unprecedented increases in life expectancy have raised important concerns for retirement savings. We solve a life-cycle model with longevity risk, which can be hedged through endogenous saving and retirement decisions. We investigate the benefits of financial assets designed to hedge the shocks to survival probabilities. When longevity risk is calibrated to match forward-looking projections, those benefits are substantial. This lends support to the idea that such hedging should be pursued by defined benefit pension plans on behalf of their beneficiaries. Finally, we draw implications for optimal security design.

Structural Results for Combined Continuous User Authentication and Intrusion Detection in High Security Mobile Ad-Hoc Networks

Continuous user authentication is an important prevention-based approach to protect high security mobile ad-hoc networks (MANETs). On the other hand, intrusion detection systems (IDSs) are also important in MANETs to effectively identify malicious activities. Considering these two approaches jointly is effective in optimal security design taking into account system security requirements and resource constraints in MANETs. To obtain the optimal scheme of combining continuous user authentication and IDSs in a distributed manner, we formulate the problem as a partially observable Markov decision process (POMDP) multi-armed bandit problem. We present a structural results method to solve the problem for a large network with a variety of nodes. The policies derived from structural results are easy to implement in practical MANETs. Simulation results are presented to show the effectiveness and the performance of the proposed scheme.

Longevity Risk, Retirement Savings and Financial Innovation

Over the last couple of decades there have been unprecedented, and to some extent unexpected, increases in life expectancy which have raised important concerns for retirement savings and for the affordability of defined-benefit pension plans. We address questions concerning these topics by introducing longevity risk in the standard life-cycle model of consumption and savings decisions. We allow individuals to hedge this risk through endogenous saving and retirement decisions and, investigate the extent to which they would benefit from investing in financial assets designed to hedge shocks to survival probabilities. We find that, when longevity risk is calibrated to match forward-looking projections the benefits of such investment are substantial. This lends support to the idea that such hedging should be pursued by defined-benefit pension plans on behalf of their beneficiaries. Finally, we draw implications for optimal security design.