Optimal securities under adverse selection and moral hazard (Q1026249)

The author constructs a simple asymmetric information model that provides a rationale for the use of warrants. He abstracts from taxes, financial distress, bankruptcy and other agency costs. He considers a model involving both adverse selection and (effort) moral hazard. There are two types of firms (projects): good and bad. Given identical effort levels, the success probability is the same for both types of projects but in case of success the good project's return is higher (first-order stochastic dominance). In the event of failure, regardless of this type, the project's return is zero. As a benchmark, the author first considers the case where moral hazard is not binding. In this case, the role of securities is to convey socially costless information about the type of the project. The introduction of moral hazard into an adverse selection framework has significant effects both on the combinations of the securities issued in equilibrium and their pricing.