Dynamic Incentives with Event Risk

Posted: 16 Feb 2015

See all articles by Enrico Biffis

Enrico Biffis

Imperial College Business School

Caterina Lepore

Imperial College Business School

Date Written: February 15, 2015

Abstract

We develop a continuous-time model in which a principal hires an agent to run a risky project exposed to unpredictable events that may generate potentially large losses. Although event occurrences are beyond the control of the agent, the distribution of the losses they generate is shaped by the agent's risk mitigation effort. Realized cash flows and event occurrences are publicly observable, but effort is private information to the agent, who is protected by limited liability. We study optimal incentive contracts, and show how they strike a delicate balance between supporting and punishing the agent in the face of downside risk.

Keywords: repeated moral hazard, limited liability, event risk, stochastic liquidation

JEL Classification: C61, D82, D86

Suggested Citation

Biffis, Enrico and Lepore, Caterina, Dynamic Incentives with Event Risk (February 15, 2015). Available at SSRN: https://ssrn.com/abstract=2565595

Enrico Biffis

Imperial College Business School ( email )

Imperial College London
South Kensington campus
London, SW7 2AZ
United Kingdom

Caterina Lepore (Contact Author)

Imperial College Business School ( email )

South Kensington Campus
Exhibition Road
London SW7 2AZ, SW7 2AZ
United Kingdom

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