Private Information and the Design of Securities

One often quoted reason for the incompleteness of financial markets is the fact that an informational asymmetry prevents entrepreneurs to float their company on the market. In fact, the privileged information that the owners have on their firms discourages rational financial investors and thins the market. The paper studies the validity of this argument in a model similar to Grossman-Stiglitz (1980). An entrepreneur who contemplates issuing a new security faces a trade-off between speculative gains, which arise from his privileged information, and an insurance motive, associated with the insurance provided by the stock market. We study the terms of this arbitrage as a function of the fundamentals of the economy: aggregate risk, risk tolerance, precision of the privileged information.