Dynamic Security Design
Centre for Economic Policy Research (CEPR)
University of Toulouse I
University of Toulouse 1 - Toulouse School of Economics (TSE)
University of Toulouse I - Institut d'Economie Industrielle (IDEI); Centre for Economic Policy Research (CEPR); Swiss Finance Institute; University of Zurich - Swiss Banking Institute (ISB)
CEPR Discussion Paper No. 4753
We analyze dynamic financial contracting under moral hazard. The ability to rely on future rewards relaxes the tension between incentive and participation constraints, relative to the static case. Managers are incited by the promise of future payments after several successes and the threat of liquidation after several failures. The more severe the moral hazard problem, the greater the liquidation risk. The optimal contract can be implemented by holding cash reserves and by issuing debt and equity. The firm is liquidated when it runs out of cash. Dividends are paid only when accumulated earnings reach a certain threshold. In the continuous time limit of the model, stocks follow a diffusion process, with a stochastic volatility that increases after price drops. In line with empirical findings, performance shocks induce long lasting changes in leverage.
Number of Pages in PDF File: 51
Keywords: Security design, moral hazard, asset pricing, dynamic financial contracting
JEL Classification: D82, G12, G32, G35working papers series
Date posted: February 8, 2005
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