Research Discussion Papers, Bank of Finland
Are adverse selection models of debt robust to changes in market structure?
Abstract: Many adverse selection models of standard one-period debt
contracts are based on the following seemingly innocuous assumptions.
First, entrepreneurs have private information about the quality of their
return distributions. Second, return distributions are ordered by the
monotone likelihood-ratio property. Third, financiers’ payoff functions are
restricted to be monotonically non-decreasing in firm profits. Fourth,
financial markets are competitive. We argue that debt is not an optimal
contract in these models if there is only one (monopoly) financier rather
than an infinite number of competitive financiers.
Keywords: security design; adverse selection; monotonic contracts; monotone likelihood ratio; first-order stochastic dominance; (follow links to similar papers)
JEL-Codes: D82; G35; (follow links to similar papers)
34 pages, November 11, 2003
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