Abstract

http://ssrn.com/abstract=891691
 
 

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Timing of Effort and Reward: Three-Sided Moral Hazard in a Continuous-Time Model


Jun Yang


Indiana University Bloomington - Kelley School of Business - Department of Finance

May 10, 2010


Abstract:     
This paper studies a three-sided moral hazard problem with one agent exerting upfront effort and two agents exerting ongoing effort in a continuous-time model. The agents' effort jointly affects the probability of survival and thus the expected cash flow of the project. In the optimal contract, the timing of payments reflects the timing of effort: payments for upfront effort precede payments for ongoing effort. Several patterns are possible for the cash allocation between the two agents with ongoing effort. In one case where the two agents face equally severe moral hazard, they share the cash flow equally at each point of time. In another case where the two agents have different severities of moral hazard, their payments are sequential. In a more general case, the two agents with ongoing effort split the cash flow first over time and then over quantity at each point of time. This study provides a framework to understanding a broad set of contracting issues in business. The characteristics suggested in the optimal contract help us identify the causes of business failures such as the recent debacle of Mortgage-Backed Securities (MBS).

Number of Pages in PDF File: 39

Keywords: Optimal Contract, Incentives, Three-sided moral hazard, Continuous time

JEL Classification: D82, M52

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Date posted: March 16, 2006 ; Last revised: July 26, 2010

Suggested Citation

Yang, Jun, Timing of Effort and Reward: Three-Sided Moral Hazard in a Continuous-Time Model (May 10, 2010). Available at SSRN: http://ssrn.com/abstract=891691 or http://dx.doi.org/10.2139/ssrn.891691

Contact Information

Jun Yang (Contact Author)
Indiana University Bloomington - Kelley School of Business - Department of Finance ( email )
1309 E. 10th St.
Bloomington, IN 47405
United States
812-855-3395 (Phone)
812-855-5875 (Fax)
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