Dynamic Financial Contracting with Persistent Private Information

51 Pages Posted: 25 Jan 2016 Last revised: 1 May 2019

See all articles by Shiming Fu

Shiming Fu

School of Finance, Shanghai University of Finance and Economics

R. Vijay Krishna

Florida State University - Department of Economics

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

Fu, Shiming and Krishna, R. Vijay, Dynamic Financial Contracting with Persistent Private Information (October 21, 2018). RAND Journal of Economics, 2019, Vol. 50 No. 2, pp. 418-452, Available at SSRN: https://ssrn.com/abstract=2721428 or http://dx.doi.org/10.2139/ssrn.2721428

Shiming Fu (Contact Author)

School of Finance, Shanghai University of Finance and Economics ( email )

777 Guoding Road
Shanghai, AK Shanghai 200433
China

R. Vijay Krishna

Florida State University - Department of Economics ( email )

Tallahassee, FL 30306-2180
United States

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