Financial Economics

WEB–APPENDIX A

DEAL TERMS

In this appendix we discuss how the terms of a financial deal can fine-tune the capabilities financiers utilize in a deal's governance. In particular, the informational conditions under which a deal is originated, and the likely evolution of that information, have important implications for selecting deal terms.

A.1 COSTS OF DEALS

Deals with differing attributes will usually be arranged at differing interest rates in order to compensate for the risk or uncertainty involved. The difference between the effective interest rate¹ charged to a client and the interest cost of funds to the financier will vary according to the deal's particular attributes, the governance capabilities of the financier, and the competitiveness of the environment in which the financing is arranged. For example, a market exchange of bonds is usually a risky deal based on information publicly available to both parties. In such a transaction the difference between financiers' total interest cost and the effective rate paid by the client will not usually be large, especially if the market is competitive. On the other hand, financing a new business venture represents a deal under uncertainty, and the parties are likely to have quite different information about possible payoffs. The interest premium for facing uncertainty, and for incurring transactions and information processing costs, is therefore likely to be greater—in some cases very much greater—than in the bond deal. Moreover, the ...