Portfolio Liquidation and Security Design with Private Information

We consider the problem faced by a privately informed issuer holding a portfolio of securities that can be sold to raise cash. If good news about one security is good news for all the securities held, then a unique equilibrium satisfies the Intuitive Criterion. If, in addition, the securities can be ordered in terms of their sensitivity to the issuer’s private information, then the issuer sells the least information-sensitive securities first. This result confirms the Pecking-Order Hypothesis. We also show that splitting a given security into smaller tranches increases the issuer’s payoff. Finally, we study applications of these results to ex post security design under asymmetric information. A unique equilibrium survives the Intuitive Criterion when signals and shocks are discrete. By taking limits we obtain an equilibrium of the continuous model, which is given by a simple differential equation. Moreover, the issuer's expected profits in the discrete model converge uniformly to her profits in the continuous model. † DeMarzo: Stanford, CA 94305-5015; [email protected]. Frankel: Ames, IA 50011; [email protected]. Jin: Shanghai 200433, China; [email protected]. We are grateful to seminar participants at the Haas School of Business and to Ashwin Alankar for research assistance.