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Scale Effects in Dynamic Contracting

Friday, April 21, 2017
12:00 PM - 1:00 PM
Location: Baxter 127
Guillaume Roger, Senior Lecturer in Economics, University of Sydney

Abstract: We study a continuous-time contracting problem in which size plays a role. The agent may take on excessive risk to enhance short-term gains; doing so exposes the principal to large, infrequent losses. The optimal contract includes size as an instrument: downsizing along the equilibrium path may be necessary so as to preserve incentive compatibility. We characterize the value function and the downsizing process, which depend on the nature of the liquidation value. When the latter has a fixed and a size-dependent component, there is an optimal liquidation size determined by the principal. In the special case where the liquidation value is linear in size, one may describe the solution in size-adjusted terms, which allows for the study of reinvestment. The optimal contract is implemented using the full array of financial securities plus debt covenants; holding equity is essential to curb risk taking. Conflicts emerge between classes of security holders and explain phenomena like seniority of claims. Firms for which risk taking is less attractive can afford a higher leverage.

Joint paper with Santiago Moreno (University of Zurich)

Series: Linde Institute/Social and Information Sciences Laboratory Seminar Series (SISL)
For more information, please phone x4220 or email sjc@hss.caltech.edu or visit https://www.hss.caltech.edu/file/morenorogerxsrisk-sisl-paper-4-21-17pdf

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