Question
Suppose the return of an investment project, R (), is normally distributed with mean and variance 2. The project costs 1. An entrepreneur has mean-variance
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Suppose the return of an investment project, R (), is normally distributed with mean and variance 2. The project costs 1. An entrepreneur has mean-variance preferences represented by the utility function u. The absolute risk aversion coefficient is > 0, the investor has initial wealth W0 + 1 and, therefore, end of period wealth W0 + R () after investment. The expected utility is
Eu(W0 + R () = u(W0 + 22) (1) Although the entrepreneur has sufficient funds to self-finance the project, he can also seek
outside financing from a risk-neutral investor.
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Leland and Pyles (1977) paper describes a signaling equilibrium for this situation. In this signaling equilibrium, what is being signaled, and how
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Derive the Leland and Pyle equilibrium algebraically.
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