DP4753 Dynamic Security Design

Author(s): Bruno Biais , Thomas Mariotti , Guillaume Plantin , Jean-Charles Rochet

Publication Date: November 2004

Keyword(s): security design , moral hazard , asset pricing , Dynamic Financial Contracting

JEL(s): D82 , G12 , G32 , G35

Programme Areas: Financial Economics

Link to this Page: www.cepr.org/pubs/dps/DP4753.asp

We analyse 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. Managers are incited 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 by 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, stocks 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.