Dynamic Security Design

Posted: 8 Jan 2005

See all articles by Bruno Biais

Bruno Biais

Centre for Economic Policy Research (CEPR)

Thomas Mariotti

University of Toulouse I

Guillaume Plantin

University of Toulouse 1 - Toulouse School of Economics (TSE)

Jean-Charles Rochet

Swiss Finance Institute; University of Geneva - Geneva Finance Research Institute (GFRI); University of Zurich - Swiss Banking Institute (ISB)

Multiple version iconThere are 2 versions of this paper

Date Written: October 2004

Abstract

We analyze dynamic financial contracting under moral hazard. The ability to rely on future rewards relaxes the tension between incentive and participation constraints relative to the static case. Entrepreneurs are incited to effort by the promise of future payments after several successes and the threat of liquidation after several failures. The more severe the moral hazard problem, the greater the liquidation risk. The optimal contract can be implemented by holding cash reserves and issuing debt and equity. The firm is liquidated when it runs out of cash. Dividends are paid only when accumulated earnings reach a certain threshold. In the continuous-time limit of the model, stock prices follow a diffusion process, with a stochastic volatility that increases after price drops. In line with empirical findings, performance shocks induce long lasting changes in leverage.

Keywords: Security design, dynamic financial contracting, moral hazard, asset pricing

JEL Classification: G12, G32, G35, D82

Suggested Citation

Biais, Bruno and Mariotti, Thomas and Plantin, Guillaume and Rochet, Jean-Charles, Dynamic Security Design (October 2004). Available at SSRN: https://ssrn.com/abstract=621121

Bruno Biais (Contact Author)

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Thomas Mariotti

University of Toulouse I ( email )

Toulouse, 31000
France

Guillaume Plantin

University of Toulouse 1 - Toulouse School of Economics (TSE) ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

Jean-Charles Rochet

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

University of Geneva - Geneva Finance Research Institute (GFRI) ( email )

40 Boulevard du Pont d'Arve
Geneva 4, Geneva 1211
Switzerland

University of Zurich - Swiss Banking Institute (ISB) ( email )

Plattenstrasse 14
CH-8032 Zurich, Zurich 8032
Switzerland

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