Dynamic Agency and Endogenous Risk-Taking

41 Pages Posted: 4 Apr 2015 Last revised: 27 Nov 2017

See all articles by Tak-Yuen Wong

Tak-Yuen Wong

Shanghai University of Finance and Economics - Department of Finance

Date Written: November 12, 2017

Abstract

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

Wong, Tak-Yuen, Dynamic Agency and Endogenous Risk-Taking (November 12, 2017). Available at SSRN: https://ssrn.com/abstract=2589511 or http://dx.doi.org/10.2139/ssrn.2589511

Tak-Yuen Wong (Contact Author)

Shanghai University of Finance and Economics - Department of Finance ( email )

Shanghai, 200433
China

HOME PAGE: http://sites.google.com/site/etywong110/

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