Robust Security Design
45 Pages Posted: 14 Jan 2017 Last revised: 29 Jul 2020
Date Written: December 8, 2018
We consider the optimal contract between an entrepreneur and investors in a moral hazard model when both parties have limited liability, are risk-neutral toward cash flow risk, and are ambiguity-averse. In the static setting, the first-best security is either convertible debt or levered equity. The optimal second-best security has an equity-like component in high cash flow states. Finally, if the two parties can renegotiate the contract after acquiring more information, the initial contract is risky debt. It is later renegotiated to a security with an equity component, and the conversion factor depends on the information acquired in the interim.
Keywords: Optimal Security Design, Robustness, Moral Hazard, Ambiguity aversion, limited liability, optimal contract
JEL Classification: G32, D82, D86
Suggested Citation: Suggested Citation