Dynamic Financial Contracting with Persistent Private Information
51 Pages Posted: 25 Jan 2016 Last revised: 1 May 2019
Date Written: October 21, 2018
Abstract
We study a dynamic agency model where the agent privately observes the firm's cash flows that are subject to persistent shocks. We characterize the policy dynamics and implement the optimal contract by financial securities. Because bad performance distorts investors' beliefs downward, the agent has less incentive to misrepresent information. The agent's compensation is less than what he can divert and is convex in performance. As private information becomes more persistent, (i) the agent is compensated more by stock options; (ii) firm credit limits vary more with history, dropping after bad performance; (iii) the firm is financially constrained for longer time.
Keywords: Dynamic agency, Markovian information, Payout, Capital structure, Investment.
JEL Classification: D82, D86, D92, G32, G35
Suggested Citation: Suggested Citation