Dynamic Moral Hazard and Risk-Shifting Incentives in a Leveraged Firm
54 Pages Posted: 8 Nov 2017 Last revised: 15 Jan 2019
Date Written: January 14, 2019
I develop an analytically tractable model that integrates the risk-shifting problem between bondholders and shareholders with the moral hazard problem between shareholders and the manager. The presence of managerial moral hazard exacerbates the risk-shifting problem. An optimal contract binds shareholders and the manager. The flexibility of this contract allows shareholders to relax the incentive constraint of the manager when a good profitability shock is drawn. Hence, the optimal contract amplifies the upside thereby increasing shareholder appetite for risk-shifting. Moreover, some empirical studies find a positive relation between risk-shifting and leverage, while others studies find a negative relation. The model predicts a non-monotonic relation between risk-shifting and leverage and has the potential to reconcile this empirical evidence.
Keywords: Risk-shifting, Moral Hazard, Principal-Agent Problem
JEL Classification: D86
Suggested Citation: Suggested Citation