Large risks, limited liability, and dynamic moral hazard

Biais, B., Mariotti, T., Rochet, J.C. & Villeneuve, S. (2010). Large risks, limited liability, and dynamic moral hazard. Econometrica, 78(1), pp. 73-118. doi: 10.3982/ECTA7261

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Abstract

We study a continuous-time principal-agent model in which a risk-neutral agent with limited liability must exert unobservable effort to reduce the likelihood of large but relatively infrequent losses. Firm size can be decreased at no cost or increased subject to adjustment costs. In the optimal contract, investment takes place only if a long enough period of time elapses with no losses occurring. Then, if good performance continues, the agent is paid. As soon as a loss occurs, payments to the agent are suspended, and so is investment if further losses occur. Accumulated bad performance leads to downsizing. We derive explicit formulae for the dynamics of firm size and its asymptotic growth rate, and we provide conditions under which firm size eventually goes to zero or grows without bounds. © 2010 The Econometric Society.

Item Type: Article
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Uncontrolled Keywords: Martingale representation theorem, delay differential equation, free boundary problem, verification theorem, Markov process, law of large numbers.
Subjects: H Social Sciences > HA Statistics
H Social Sciences > HB Economic Theory
H Social Sciences > HD Industries. Land use. Labor > HD61 Risk Management
H Social Sciences > HG Finance
Divisions: Cass Business School > Faculty of Finance
URI: http://openaccess.city.ac.uk/id/eprint/17633

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