information aggregation, security design and currency swaps.pdf

Information Aggregation, Security Design and Currency Swaps Bhagwan Chowdhry Mark Grinblatt David Levine1 July 2001 1University of California, Los Angeles. We are grateful to Sushil Bikhchan- dani, Tony Bernardo, John Cochrane (the editor), Peter DeMarzo, John Riley, and seminar participants at UBC, UC Irvine, UCLA, University of Colorado at Boul- der, McGill, and Penn State University, and three anonymous referees for helpful comments on earlier drafts. Abstract A security design model shows that multinational firms needing to finance their operations should issue different securities to investors in different countries in order to aggregate their disparate information about domes- tic and foreign cash flows. However, if the firm becomes bankrupt, investors may face uncertain costs of reorganizing assets in a foreign country and thus may value foreign assets at their average value. This penalizes superior firms with low reorganization costs. Such firms minimize the adverse selection penalty by designing securities that allocate all the cash flow in bankruptcy to investors for which the adverse selection costs are the smallest given the exchange rate. We show that this sharing rule can be implemented with currency swaps because these instruments allow the priorities of claims in bankruptcy to switch depending on the exchange rate. I. Introduction One of the long held tenets of financial economics, dating back to the Modigliani and Miller capital structure propositions, is that in a perfect capital market, the precise packaging and marketing of securities is irrele- vant. However, the practice of finance since the 1980’s is largely noted for the proliferation of new contractual arrangements that package secu