Informational asymmetries in underdeveloped securities markets, optimal financial contracts, and regulation

This dissertation develops a formal model of a primary equity market in which costly state verification and asymmetric information require auditing policies and enforcement power to guarantee an efficient (second best) equilibrium and avoid market failure. The model captures some essential features of Third World capital markets, including unequal investment opportunity sets and the related asymmetry in information that results from a small group of insiders having controlling interests in most firms. The model is sued to determine the optimal financial contract that is incentive compatible under the assumed asymmetric information structure and strict limited liability. Firms have random returns which can be verified by costly audits. A contract specifies the payoffs to the parties for each distinguishable state of nature, and the auditing procedure to be followed. Allowing for random auditing, a class of contracts is shown to be optimal under the condition that payoffs be restricted to fixed fractions of verified returns. This class of contracts encompasses both standard debt contracts and standard equity contracts. The exact nature of the optimal contract is shown to depend on the probability distribution of returns. If more than one contract is allowed, it is shown that an optimal capital structure arises from the trade off between the agency costs associated with different financial contracts.