Optimal Financial Contracting and Risk-Shifting

45 Pages Posted: 28 Feb 2019 Last revised: 5 Aug 2019

Date Written: August 3, 2019

Abstract

I study optimal financial contracting when neither cash flows nor the risk profile of project choices are verifiable. Using a contracting framework, I show the resulting two frictions (cash-diversion and asset-substitution) are intricately linked: to address the cash-diversion problem, an optimal contract resembles a debt contract, which in turn causes the asset-substitution problem. A key finding of this paper is that, due to the potential shift of control rights to the investor, the firm does not have an excessive risk-taking incentive; in fact, my model predicts that the firm may choose an excessively safe risk-profile. Also, my model highlights the role of the financial market structure (private vs. public debt): the asset substitution problem increases the cost of public debt, but lowers that of private debt. Strikingly, however, regardless of the market structure, the asset-substitution problem leads to a more efficient risk-profile choice.

Keywords: cash-diversion problem, asset-substitution problem, risk-shifting (ex-post risk-taking), capital rationing, debt contracting

JEL Classification: D82, D86, G32, G33

Suggested Citation

Han, DongJoon, Optimal Financial Contracting and Risk-Shifting (August 3, 2019). Available at SSRN: https://ssrn.com/abstract=2978645 or http://dx.doi.org/10.2139/ssrn.2978645

DongJoon Han (Contact Author)

CUHK Business School ( email )

Cheng Yu Tung Building
12 Chak Cheung Street
Shatin, N.T.
Hong Kong

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