F INANCE R ESEARCH S EMINAR S UPPORTED BY U NIGESTION " Demand - Based Security Design

Uninformed investors facing future carrying cost (liquidity) shocks determine primary market prices for asset-backed securities. A liquidity provider subsequently buys tendered securities in competitive secondary markets. Liquidity provision is distorted by a speculator receiving a private signal regarding cash flow. Optimal structuring minimizes total trading loss and carrying cost discounts demanded by uninformed investors. If uninformed selling is price-insensitive noise-trading, all structurings generate equal discounts. With optimizing uninformed investors, security design is relevant as it alters their secondary market trading, optimally liquefying an otherwise illiquid cash flow stream or de-liquefying an otherwise liquid cash flow stream. The optimal structuring entails tranching. With fixed speculator information, the optimal senior face value entails a tradeoff, with increases in senior face reducing total expected carrying costs but increasing total expected trading losses. This privately optimal structuring is socially suboptimal, as the desire to reduce speculator gains generates excessive illiquidity. With discretionary speculator effort, tranching can either stimulate or deter information production as it can increase or decrease uninformed trading volume. Tranching remains optimal with discretionary speculator effort, but as a deterrent, optimal senior face value is lowered. Friday, March 1st, 2013, 10.30-12.00 Room 126, 1st floor of the Extranef building at the University of Lausanne Demand-Based Security Design∗ Christopher A. Hennessy†