Robust Security Design

45 Pages Posted: 14 Jan 2017 Last revised: 29 Jul 2020

See all articles by Seokwoo Lee

Seokwoo Lee

University of Maryland - Robert H. Smith School of Business

Uday Rajan

Stephen M. Ross School of Business, University of Michigan

Date Written: December 8, 2018

Abstract

We consider the optimal contract between an entrepreneur and investors in a moral hazard model when both parties have limited liability, are risk-neutral toward cash flow risk, and are ambiguity-averse. In the static setting, the first-best security is either convertible debt or levered equity. The optimal second-best security has an equity-like component in high cash flow states. Finally, if the two parties can renegotiate the contract after acquiring more information, the initial contract is risky debt. It is later renegotiated to a security with an equity component, and the conversion factor depends on the information acquired in the interim.

Keywords: Optimal Security Design, Robustness, Moral Hazard, Ambiguity aversion, limited liability, optimal contract

JEL Classification: G32, D82, D86

Suggested Citation

Lee, Seokwoo and Rajan, Uday, Robust Security Design (December 8, 2018). Ross School of Business Paper No. 1338, Available at SSRN: https://ssrn.com/abstract=2898462 or http://dx.doi.org/10.2139/ssrn.2898462

Seokwoo Lee (Contact Author)

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States

HOME PAGE: http://https://sites.google.com/a/umich.edu/seokwoo-lee/home

Uday Rajan

Stephen M. Ross School of Business, University of Michigan ( email )

701 Tappan Street
Ann Arbor, MI 48109
United States
734-764-2310 (Phone)

HOME PAGE: http://webuser.bus.umich.edu/urajan

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
135
Abstract Views
884
rank
263,179
PlumX Metrics