Securitization and real investment in incomplete markets

We study the impact of financial innovations on real investment decisions within the framework of an incomplete market economy comprised of firms, investors, and an intermediary. The firms face unique investment opportunities that arise in their business operations and can be undertaken at given reservation prices. The cash flows thus generated are not spanned by the securities traded in the financial market and cannot be valued uniquely. The intermediary purchases claims against these cash flows, pools them together, and sells tranches of primary or secondary securities to the investors. We derive necessary and sufficient conditions under which projects are undertaken due to the intermediary's actions, and firms are amenable to the pool proposed by the intermediary, compared to the no-investment option or the option of forming alternative pools. We also determine the structure of the new securities created by the intermediary and identify how it exploits the arbitrage opportunities available in the market. Our results have implications for valuation of real investments, synergies among them, and their financing mechanisms. We illustrate these implications using an example of inventory decisions under random demand. Key words: incomplete markets; securitization; financial innovation; real options; project financing History: Received August 15, 2007; accepted October 28, 2009, by John Birge, focused issue editor. Published online in Articles in Advance March 23, 2010.
1. Introduction In the standard paradigm of financial economics, the value of a project is derived from capital market prices based on the twin assumptions that the cash flows from [...]