Optimal Security Design under Asymmetric Information and Profit Manipulation

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Publication details

JournalReview of Corporate Finance Studies
DateE-pub ahead of print - 28 Nov 2018
DatePublished (current) - 1 Mar 2019
Issue number1
Number of pages28
Pages (from-to)146–173
Early online date28/11/18
Original languageEnglish


We consider a model of external financing in which entrepreneurs are privately
informed about the quality of their projects and seek funds from competitive financiers. The literature restricts attention to monotonic, or “manipulation proof,” securities and finds that straight debt is the uniquely optimal contract. Monotonicity is commonly justified by the argument that it would endogenously arise if the entrepreneur can window dress the realized earnings before contract maturity. We explicitly characterize the optimal contracts when entrepreneurs engage in window dressing and/or output diversion and derive necessary and sufficient conditions for straight debt to be optimal. Contrary to conventional wisdom, debt is often suboptimal, and it is never uniquely optimal. Optimal contracts are nonmonotonic and induce profit manipulation in equilibrium. They can be implemented as performance-sensitive debt.

Bibliographical note

© The Author(s) 2018. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. This is an author-produced version of the published paper. Uploaded in accordance with the publisher’s self-archiving policy. Further copying may not be permitted; contact the publisher for details.

    Research areas

  • security design, capital structure, asymmetric information, profit manipulation, window dressing

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