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We use the tools of mechanism design, combined with the theory of risk
measures, to analyze how a cash constrained owner of an asset with known,
stochastic returns raises capital from a population of investors that differ in
their risk aversion and budget constraints. The issuer partitions the asset’s
cash flow into several asset-backed securities, one for each type of investor. The
optimal partition conforms to the commonly observed practice of tranching into
senior debt, junior debt and equity. Tranching endogenously arises due to the
differences in risk appetites among agents, and in the budget constraints they
face.
