Dynamic Asset Allocation with Hidden Volatility
50 Pages Posted: 23 Nov 2016 Last revised: 17 Jun 2018
Date Written: June 10, 2018
We study a continuous-time principal-agent model with endogenous cash-flow volatility. The principal supplies the agent with capital for productive use, but the agent can misallocate capital for private benefit and has private control over both project volatility and investment size. The optimal contract can yield either overly-risky or overly-prudent project selection. It can be implemented with a static two-part tariff on capital (fixed cost plus hurdle rate) while giving the agent control over the quantities of capital, risk, and equity share. Our model captures stylized facts about the use of hurdle rates and capital charges in practice.
Keywords: dynamic agency, volatility control, capital budgeting, cost of capital, continuous time
JEL Classification: D86, D82, G31
Suggested Citation: Suggested Citation