Dynamic Agency and Endogenous Risk-Taking
41 Pages Posted: 4 Apr 2015 Last revised: 27 Nov 2017
Date Written: November 12, 2017
I study a continuous-time principal-agent model in which a multitasking agent engages in unobserved risk-taking. Risk-taking creates short-term profits but also increases the chance of large losses. The optimal contract incentivizes excessive risk-taking when the agent has insufficient skin in the game. Moreover, if the low effort is not too value-destroying and the private benefit of shirking is low enough, the principal can eliminate risk-taking by implementing the low effort. However, with variable project scale, addressing the risk-taking incentives by downsizing projects is not optimal. The implementation of the optimal contract shows that risk management should take agency problems into account. Complete hedging against downside risks provides incentives for the agent to gamble.
Keywords: Dynamic Contract, Moral Hazard, Risk-Taking, Risk Management
JEL Classification: C61, D86, G11, G32, J33
Suggested Citation: Suggested Citation