Robust Security Design

We consider the optimal contract between an entrepreneur and investors in a single-period model when both parties have limited liability, are risk-neutral toward cash flow risk, and are ambiguity-averse. Ambiguity aversion is modeled by multiplier preferences for robustness toward model uncertainty, as in Hansen and Sargent (2001). Efficient ambiguity-sharing implies that the first-best contract consists of either convertible debt or levered equity. As is customary, in the second-best contract, moral hazard is alleviated by giving more cash to investors in low cash flow states. Under many settings in our model, the optimal security has an equity-like component in high cash flow states, providing a contrast to the results in Innes (1990). ∗We are grateful to Archishman Chakraborty, Simon Gervais, Francesco Sangiorgi, Martin Szydlowski ,and participants at the Minnesota Corporate Finance Conference and Finance Theory Group Conference for helpful comments. †George Mason University; [email protected] ‡Stephen M. Ross School of Business, University of Michigan; [email protected]