Unobservable Costly Effort in Security Design

I introduce unobservable costly effort into the canonical signalling model of security design. The choice of effort determines the quality of the security and creates an additional optimisation problem the firm must solve. My main result is that both optimal effort and optimal profits are decreasing in the firm’s preference for liquidity. I also show that optimal effort is greater under symmetric information. My approach provides a theoretical explanation for empirical results that cannot be obtained within the standard signalling framework. In addition, I extend existing methods to solve signalling models with endogenous private information.