A review of possible solution(s) to the winner’s curse and adverse selection problems in capital markets

Abstract

This report explores how firms communicate private information through choice of security in the capital market characterized by asymmetric information and adverse selection. Focusing on hybrid securities such as unit IPO and convertible bonds, a review of contemporary literature has been conducted to analyze how security choice influences investor’s belief and financing outcome. Based on the understanding developed from reviewing literatures, a signaling game has been developed, demonstrating conditions under which low type firm can mimic high type firm and achieve financing aims. The game theoretic framework also suggested certain conditions leading separating equilibrium where high type firm can separate itself through security choice. Overall, this study highlights the importance of hybrid securities’ flexibility and identifies their features functioning not only as a financial tool but also as a credible signaling mechanism.