Asymmetric Information and Signaling (Ross 1977) PDF

Introduction Lemons problem Ross (1977) Asymmetric information & Signaling (I) Alexander Schandlbauer 1 / 21  Introduction Lemons problem Ross (1977)...

Introduction Lemons problem Ross (1977) Asymmetric information & Signaling (I) Alexander Schandlbauer 1 / 21  Introduction Lemons problem Ross (1977) What is meant by asymmetric information? 3 / 21  Introduction Lemons problem Ross (1977) Basic problem in corporate finance: separation of ownership and control The owners (shareholders) of the firm are typically not the ones who manage it on a daily basis. The owners (principal) delegate tasks to managers (agent) Yet, managers have their own objective function. ▶ They may not exert much effort, e.g. because it is costly for them. The way to solve the problem would be to write a contract that compensates the manager on the basis of his effort. → Unfortunately, effort is typically unobservable (asymmetric information) Hence, we write contracts that compensate the manager based on performance, which is a noisy signal of manager’s effort. ▶ This might be costly when the manager is risk averse, since extra compensation is needed for the risk taken. 4 / 21  Introduction Lemons problem Ross (1977) Motivation: Credit rationing What is credit rationing? Quoting Bester and Hellwig (1987): “A would-be borrower B is said to be (credit) rationed if he cannot obtain the loan that he wants even though he is willing to pay the interest rate that the lenders are asking, perhaps even a higher inter- est.” Are those short-term disequilibrium effects? No, seems to be an equilibrium phenomenon driven by the asymmetry of information between borrowers and lenders. 5 / 21  Introduction Lemons problem Ross (1977) Motivation: Credit rationing (continued) Effect of higher interest rates: reduces B’s stake in the project lower B’s income in case of of success no effect in case of bankruptcy (limited liability) Moral hazard explanation: B acts inefficiently, e.g. undertakes projects with private benefits engage in fraud undertakes high-risk project → reduced stake (due to higher interest rates) demotivates borrower Adverse selection explanation: high interest rates will attract low-quality borrowers because those are more likely to default 6 / 21  Introduction Lemons problem Ross (1977) Adverse selection Market breakdown: The Lemons Problem George Akerlof (1970): consider a market for used cars with symmetric information: quality (type) of car is known with asymmetric information: quality is unknown to buyers question: what will a buyer pay for a car? illustration [Blackboard] 8 / 21  Introduction Lemons problem Ross (1977) The publication of the paper...... ▶... ▶... ▶...... 9 / 21  Introduction Lemons problem Ross (1977) 2001:... “for their analyses of markets with asymmetric information” George Akerlof, Michael Spence and Joseph Stiglitz Examples of problems dealing with asymmetric information: moral hazard, adverse selection, information monopoly 10 / 21  Introduction Lemons problem Ross (1977) How is this relevant in the context of corporate finance? Why do firms issue claims? financing of (new) projects risk sharing liquidity ⇒ motivated by existence of gains from trade between the issuer and the investor But under asymmetric information fourth motivation: pushing overvalued assets to investors What kind of asymmetric information? between firm insiders and investors with respect to: firm’s prospects, value of assets in place, the issuer’s potential private benefit,... 11 / 21  Introduction Lemons problem Ross (1977) How is that different from other aspects of asymmetric information? Difference between Moral hazard and Adverse selection ▶ Moral hazard: B makes “effort” choice → affects expected outcome ▶ Adverse selection: B is “born” with a “type” (e.g. high or low), but B’s type is private information to B ,→ asymmetric information Broadly speaking AS leads to two types of solutions 1 pooling equilibrium 2 separating equilibrium Key problem: high-type bears the risk of cross-subsidizing low type if separation cannot be obtained 12 / 21  Introduction Lemons problem Ross (1977) Adverse selection and applications The analysis can be applied to many different issues 1 market timing 2 negative stock price reaction and the decision to go public 3 pecking-order hypothesis — 4 certification 5 costly collateral pledging 6 short-term maturities 7 payout policy 8 diversification and incomplete insurance 9 underpricing The last six applications require dissipative signals 13 / 21  Introduction Lemons problem Ross (1977) Dissipative signals Adverse selection in general leads to cross-subsidization or even market break-down ▶ costly to good borrowers Good borrowers have an incentive to mitigate the investor’s informational disadvantage Good borrowers may be willing to pay to provide a signal Borrowers can reduce informational asymmetries by ▶ certification, through financial structure decisions (e.g., choice of debt, costly collateral pledging, payout policy) Signaling can occur because it is relatively more costly for a bad borrower to do it 14 / 21  Introduction Lemons problem Ross (1977) Ross (1977): How fims’ capital structure can act as a signal Key Question: ▶ How can managers convey true firm quality to mitigate asymmetric information? Incentive-Signaling Mechanism: ▶ Managers know true firm profitability, while investors do not ▶ Capital structure (especially debt level) is used to signal profitability ▶ Assumption: Higher-quality firms (profitable) can sustain higher debt due to ability to meet obligations Core Idea: ▶ By choosing a higher debt level, managers of profitable firms differentiate from lower-quality firms 16 / 21  Introduction Lemons problem Ross (1977) Setting up the Model - Key Players and Assumptions Main Players and Variables: ▶ Managers: Privately know the firm’s profitability level, θ ▶ Investors: Observe debt level D, not θ Utility Function for Managers: U = W − g(D) where W is the manager’s wealth (dependent on the firm’s market value) and g(D) is a penalty function increasing with debt. ▶ Assessed on the manger if the firm is in bankruptcy 17 / 21  Introduction Lemons problem Ross (1977) Debt as a Signal in Ross’s Model Debt Choice as a Signaling Mechanism: ▶ Firms select debt levels D to signal profitability Expected Utility of Debt Choice: U = W (θ, D) − g(D) One period model of manager’s compensation: ( V1 if V1 ≥ D, M = (1 + r )γ0 V0 + γ1 V1 − g, otherwise where V0 and V1 are the current and future firm value and γ0 and γ1 are weights Incentive for High-Quality Firms: ▶ High-quality firms maximize utility by choosing higher debt ▶ Low-quality firms face higher default penalties if they mimic high debt 18 / 21  Introduction Lemons problem Ross (1977) Incentive Compatibility and Separating Equilibrium Conditions under which high- and low-quality firms choose different debt levels Incentive Compatibility Condition: U(D ∗ , θH ) > U(D, θL ) for high-quality firms Only high-quality firms will select a higher debt level D ∗. ▶ High-quality firms select D ∗ to maximize U(D, θ). Equilibrium Debt Level D ∗ (θ): ∂U =0 ∂D Market Interpretation: ▶ Investors interpret D ∗ as a signal of high-quality profitability. Market’s Equilibrium Belief: ▶ Investors assign high probability to θ = θH if D = D ∗. Resulting Firm Valuation: V = E[Firm value|D = D ∗ ] = V (θH ) 19 / 21  Introduction Lemons problem Ross (1977) Implications, Applications, and Limitations Implications for Corporate Finance: ▶ Ross’s model informs capital structure decisions. ▶ High-quality firms benefit from a lower cost of capital. Applications and Extensions: ▶ Extends to dividend policies, IPOs, and mergers. Limitations of Ross’s Model: ▶ Simplifies complexities, e.g., no bankruptcy costs. 20 / 21  Introduction Lemons problem Ross (1977) Other ways to signal Signaling expected cash flows with dividends: Bahattaharya (1979) Signaling and the issue-invest decision: Myers and Majluf (1984) Stock splits: Cpeland and Brennand (1988)... 21 / 21