Chapter 2. Dynamic Security Design and Corporate Financing*

This essay considers dynamic security design and corporate financing, with particular emphasis on informational microfoundations. The central idea is that firm insiders must retain an appropriate share of firm risk, either to align their incentives with those of outside investors (moral hazard) or to signal favorable information about the quality of the firm’s assets. Informational problems lead to inevitable inefficiencies—imperfect risk sharing, the possibility of bankruptcy, investment distortions, etc. The design of contracts that minimize these inefficiencies is a central question. This essay explores the implications of dynamic security design on firm operations and asset prices.