Dynamic Incentives with Event Risk
Posted: 16 Feb 2015
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: Suggested Citation