Time Varying Adverse Selection in Credit Markets

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Time Varying Adverse Selection in Credit Markets

• Chris Yung
• Leeds School of Business
• University of Colorado

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Market Imperfections Across the Business Cycle

• An example Lewis, Rogalski and Seward (1998)
  investigate whether issuers vary convertible
  security design over the business cycle in
  response to asset substitution and adverse
  selection problems.

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Market Imperfections Across the Business Cycle

• Costly State Verification countercyclical
• Williamson (1987), Bernanke and Gertler (1989)
• Entrepreneurial Effort countercyclical
• Rampini (2004)
• Asset Substitution cyclicality is not clear
• Stiglitz and Weiss (1992)
• Credit Rationing countercyclical
• Greenwald, Stiglitz and Weiss (1984)
• Azariadas and Smith (1998)

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Intuition

• Good times (can) cause bad firms to pool
• Gains to selling a security
• NPV of the investment Mispricing

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Lenders profit function
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First-order stochastic dominance
r
Lender PC (firms pool)
Lender PC (good firm only)
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Second-order stochastic dominance
r
Lender PC (risky firm only)
Lender PC (firms pool)
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Applications

• Security design features as debt maturity, IPO
  lockups, etc.
• IPO Waves
• Merger Waves