Optimal investment decisions when time-horizon is uncertain

Many investors do not know with certainty when their portfolio will be liquidated. Should their portfolio selection be influenced by the uncertainty of exit time? In order to answer this question, we consider a suitable extension of the familiar optimal investment problem of Merton [Merton, R.C., 1971. Optimal consumption and portfolio rules in a continuous-time model. Journal of Economic Theory 3, 373–413], where we allow the conditional distribution function of an agent’s time-horizon to be stochastic and correlated to returns on risky securities. In contrast to existing literature, which has focused on an independent time-horizon, we show that the portfolio decision is affected.     

On moral hazard and nonexclusive contracts

We study an economy where intermediaries compete over contracts in a nonexclusive insurance market affected by moral hazard. In this context, we show that, contrarily to what is commonly believed, market equilibria may fail to be efficient even if the planner is not allowed to enforce exclusivity of trades (third best inefficiency). Our setting is the same as that of Bisin and Guaitoli [Bisin, A., Guaitoli, D., 2004. Moral hazard with nonexclusive contracts. Rand Journal of Economics 2, 306–328]. We hence argue that some of the equilibrium conditions they imposed are not necessary, and we exhibit a set of equilibrium allocations which fail to satisfy them.     

Optimal securities under adverse selection and moral hazard

We consider project financing under adverse selection and moral hazard and derive several interesting results. First, we provide an explanation of why good firms issue both debt and underpriced equity (even if the bankruptcy and agency costs of debt are zero). Second, we show that, in the presence of moral hazard, adverse selection may induce the conversion of negative into positive NPV projects leading to an improvement in social welfare. Third, we provide a rationale for the use of warrants. We also show that a debt–warrant combination can implement the optimal contract. Our results have a number of testable implications.     

Optimal insurance under moral hazard in loss reduction

This study investigates the optimal insurance when moral hazard exists in loss reduction. We identify that the optimal insurance is full insurance up to a limit and partial insurance above that limit. In case of partial insurance, the indemnity schedule for prudent individual is convex, linear, or concave in loss, depending on the shapes of the utility and loss distribution. The optimal insurance may include a deductible for large losses only when the indemnity schedule is convex. It may also include a fixed reimbursement when the schedule is convex or concave. When the loss distribution belongs to the one dimensional exponential family with canonical form, the indemnity schedule is concave under IARA and CARA, whereas it can be concave or convex under DARA.     

Optimal consumption and investment under partial information

We consider a stock market model where prices satisfy a stochastic differential equation with a stochastic drift process. The investor’s objective is to maximize the expected utility of consumption and terminal wealth under partial information; the latter meaning that investment decisions are based on the knowledge of the stock prices only. We derive explicit representations of optimal consumption and trading strategies using Malliavin calculus. The results apply to both classical models for the drift process, a mean reverting Ornstein-Uhlenbeck process and a continuous time Markov chain. The model can be transformed to a complete market model with full information. This allows to use results on optimization under convex constraints which are used in the numerical part for the implementation of more stable strategies. Supported by the Austrian Science Fund FWF, project P17947-N12. We thank two anonymous referees for their comments which led to a considerable improvement of the paper.     

Temporarily asymmetric information and labour contracts

Under the assumption that workers are more heavily credit rationed than firms, the standard model of testing and self-selection in the labour market is extended. The two main findings are that ex post inefficient termination may be used as a self-selection device and that when workers can be of more than two different productivities, only the best worker should be overpaid.     

Optimal production and portfolio investment decisions

This paper takes a further step towards the integration of the theories of production and finance under uncertainty. It sets up a continuous time-diffusion process model of production by firms and portfolio investment by individuals and provides a simultaneous solution to these two decisions. The derived equilibrium conditions, being in the stockholders' interest, are specific in form, and are determined by two factors: attitudes of investors towards risk and the systematic risks of the firm.     

Supply chain decisions under asymmetric information with cost and fairness concern

ABSTRACT

The two-echelon supply chain including single supplier and single retailer is set, and we study the compact of asymmetric information on the decisions in the supply chain when the both supplier’s private cost information and retailer’s private fairness-concern information are asymmetry between the supply chain members, so as to study the effect of misreporting behavior and fairness concern on the supply chain. By mathematical model derivation and numerical analysis, we prove that the misreporting behavior of supplier will intensify the unfair distribution of supply chain and thus make the supply chain operation further deviate from the optimal condition.     

Equilibrium unemployment and wage formation with matching frictions and worker moral hazard

This paper combines the shirking and the matching approaches of equilibrium unemployment in order to endogenize the wage formation process as a function of labour market conditions. The steady-state equilibrium can take two forms depending on whether the no-shirking condition is binding or not. It is demonstrated that the efficiency wage approach is relevant when the unemployment rate is above a certain threshold. Furthermore, an efficiency wage is more likely when the disutility of effort is high, recruiting costs and workers' bargaining power are low, inspections are unlikely and the workers' productivity is weak.     

Investment and capital structure decisions with strategic debt service under asymmetric information

This paper examines the agency problem due to manager-shareholder conflicts in a real option framework by incorporating strategic debt service. We show that when the equityholders’ bargaining power is weak, the optimal coupon is larger and the manager overinvests the project relative to the case without renegotiation, while the results are totally opposite when the bargaining power is strong. An increase in equityholders’ bargaining power reduces the manager’s value and the total social value. Especially, the social value can be improved by debt renegotiation when the systematic risk is high, which provides an explanation why Chinese government encourage the market-oriented debt restructuring.     

Securitization and optimal retention under moral hazard

Securitization improves liquidity in capital markets by allowing originators to remove issued loans from its balance sheet and use the proceeds for other purposes. Securitization is often suspected of being one of the main reasons for the recent financial crisis. One concern is that securitization leads to moral hazard in lender screening and monitoring. By selling loans to investors and removing them from their books, banks have a lesser incentive to carefully evaluate and monitor borrowers’ credit quality to ensure that they can repay their loans. One problem in the literature is that the analysis of securitization is very general and suffers from a lack of specific security design analysis under asymmetric information. We address the moral hazard problem using a principal–agent model where the investor is the principal and the lender is the agent. We show that the optimal contract must contain a retention clause in the presence of moral hazard. The optimal retention is affected by tranching and credit enhancement.     

Executive compensation and earnings management under moral hazard

This paper analyzes executive compensation in a setting where managers may take a costly action to manipulate corporate performance, and whether managers do so is stochastic. We show that an increase in the possibility of manipulation actually calls for executive pay to be more responsive to reported performance. In addition, regulatory reforms that increase the cost involved in manipulation may lead to reduced pay-for-performance sensitivities. The time-series and cross-sectional variations of executive compensation lend support to our model.     

Contracting under ex post moral hazard and non-commitment

This paper characterizes the optimal insurance contract in an environment where an informed agent can misrepresent the state of the world to a principal who cannot credibly commit to an auditing strategy. Because the principal cannot commit, the optimal strategy of the agent is not to tell the truth all the time. Assuming that there are T > 1 possible losses, and that the agent cannot fake an accident (he is constrained only to misreport the size of the loss when a loss occurs), the optimal contract is such that higher losses are over-compensated while lower losses are on average under-compensated. The amount by which higher losses are over-compensated decreases as the loss increases. The optimal contract may then be represented as a simple combination of a deductible, a lump-sum payment and a coinsurance provision.Received: 29 January 1999, Accepted: 26 June 2001, JEL Classification: D82, G2, C72.I would like to thank my dissertation committee Stanley Baiman, David Cummins, Georges Dionne, Neil Doherty and Sharon Tennyson (supervisor) for their insights, as well as Keith Crocker, Steve Coate, Richard Derrig, Michele Piccone and Pascale Viala. The financial help received during my doctoral studies from the Social Sciences and Humanities Research Council of Canada (SSHRC) and the S. S. Huebner Foundation are gratefully acknowledged. This research has been funded by the Fonds pour la Formation de Chercheurs et d'Aide à la Recherche (FCAR-Québec), SSHRC-Canada and the Risk Management Chair at HEC Montréal. The continuing financial support of CIRANO is also appreciated. I am responsible for all errors.     

Optimal self-financing microfinance contracts when borrowers have risk aversion and limited commitment

This paper examines optimal lending contracts between a single not-for-profit lender and a continuum of risk-averse borrowers, where the lending relationships are continually created and destroyed.  The lender self-finances its costs via income from loans, while borrowers can walk away from the current relationship in any period and search for a new relationship.  We characterize the optimal allocation by formulating the lender’s problem of maximizing social welfare and by resorting to a variational argument that takes into account the limited commitment problem and the endogenous outside option values of the borrowers.  In the benchmark case of the Benthamite social welfare function, we find that the optimal stationary allocation exhibits novel consumption dynamics: Borrower consumption begins at a relatively low level, converges toward a particular level when the participation constraint is slack, and jumps up when the participation constraint binds.  We then explore the role of limited commitment in generating such consumption dynamics and discuss the associated repayment profile.     

Optimal deterministic contracting mechanisms for principal-agent problems with moral hazard and adverse selection

For the principal-agent problem with moral hazard and adverse selection we establish that within the collection of all measurable, deterministic contracting mechanisms satisfying the individual rationality and incentive compatibility constraints there exists one that is optimal for a risk averse principal contracting with a risk averse agent. In addition to demonstrating existence, one of the main contributions of the paper is to show that, in general, centralized contracting implemented via a contracting mechanism is equivalent to delegated contracting implemented via a contract menu. Thus, contracting can always be delegated to the agent without gain or loss to the principal. Based on this result, the existence of an optimal contracting mechanism for the principal-agent problem is established by showing that there exists an optimal contract menu for the equivalent delegated contracting problem. Received: 7 October 1994 / Accepted: 14 January 1997     

Investment decisions and debt financing under information uncertainty

This study examines how information uncertainty influences investment decisions. In contrast to prior studies, which assume no information uncertainty, our model includes a discrepancy in valuing debt between shareholders and debtholders at the time of debt issuance. We derive the values of corporate securities and the optimal investment threshold and coupon under information uncertainty. We show that compared with the absence of information uncertainty, debtholders value debt less than shareholders do, and hence, shareholders should contribute more investment funds. Debt financing restraints due to information uncertainty lead to delayed investment. We find that information uncertainty plays a mitigating role in shareholder-debtholder conflicts over investment policy. Moreover, the information uncertainty costs that shareholders incur increase sharply with the level of information uncertainty.     

Inflation and output volatility under asymmetric incomplete information

The assumption of asymmetric and incomplete information in a standard New Keynesian model creates strong incentives for monetary policy transparency. We assume that the central bank has better information about its objectives than the private sector, and that the private sector has better information about shocks than the central bank. Transparency has the potential to trigger a virtuous circle in which all agents find it easier to make inferences and the economy is better stabilised. Our analysis improves upon existing work by endogenising the volatility of both output and inflation. Improved transparency most likely manifests itself in falling output volatility.     

Estimation and comparison of treasury auction formats when bidders are asymmetric

The structural parameters of a share‐auction model accounting for asymmetries across bidders, as well as supply uncertainty, are estimated with a sample of French Treasury auctions. We find evidence of both informational and risk aversion asymmetries across bidders. A counter‐factual analysis also suggests that, in the context of the French Treasury auctions, a shift from the discriminatory to the uniform‐price format would simultaneously benefit the French Treasury and the auctions' participants. Copyright © 2006 John Wiley & Sons, Ltd.     

Optimal consumption and investment under time-varying relative risk aversion

We consider the continuous time consumption-investment problem originally formalized and solved by Merton in case of constant relative risk aversion. We present a complete solution for the case where relative risk aversion with respect to consumption varies with time, having in mind an investor with age-dependent risk aversion. This provides a new motivation for life-cycle investment rules. We study the optimal consumption and investment rules, in particular in the case where the relative risk aversion with respect to consumption is increasing with age.