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Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications

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Author Info
BRUNO BIAIS
THOMAS MARIOTTI
GUILLAUME PLANTIN
JEAN-CHARLES ROCHET

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Abstract

An entrepreneur with limited liability needs to finance an infinite horizon investment project. An agency problem arises because she can divert operating cash flows before reporting them to the financiers. We first study the optimal contract in discrete time. This contract can be implemented by cash reserves, debt, and equity. The latter is split between the financiers and the entrepreneur and pays dividends when retained earnings reach a threshold. To provide appropriate incentives to the entrepreneur, the firm is downsized when it runs short of cash. We then study the continuous-time limit of the model. We prove the convergence of the discrete-time value functions and optimal contracts. Our analysis yields rich implications for the dynamics of security prices. Stock prices follow a diffusion reflected at the dividend barrier and absorbed at 0. Their volatility, as well as the leverage ratio of the firm, increase after bad performance. Stock prices and book-to-market ratios are in a non-monotonic relationship. A more severe agency problem entails lower price-earning ratios and firm liquidity and higher default risk. Copyright 2007 The Review of Economic Studies Limited.

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File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1467-937X.2007.00425.x
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Publisher Info
Article provided by Blackwell Publishing in its journal Review of Economic Studies.

Volume (Year): 74 (2007)
Issue (Month): 2 (04)
Pages: 345-390
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Handle: RePEc:bla:restud:v:74:y:2007:i:2:p:345-390

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References listed on IDEAS
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Pagès, H., 2009. "Bank incentives and optimal CDOs," Documents de Travail 253, Banque de France. [Downloadable!]
  2. Dino Gerardi & Lucas Maestri, 2008. "A Principal-Agent Model of Sequential Testing," Cowles Foundation Discussion Papers 1680, Cowles Foundation, Yale University. [Downloadable!]
  3. Tirole, Jean, 2009. "Illiquidity and All Its Friends," IDEI Working Papers 572, Institut d'Économie Industrielle (IDEI), Toulouse. [Downloadable!]
  4. Biais, Bruno & Mariotti, Thomas & Rochet, Jean-Charles & Villeneuve, Stéphane, 2007. "Large Risks, Limited Liability and Dynamic Moral Hazard," IDEI Working Papers 472, Institut d'Économie Industrielle (IDEI), Toulouse, revised Sep 2009. [Downloadable!]
  5. Noah Williams, 2008. "Persistent Private Information," NBER Working Papers 13894, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  6. Décamps, Jean-Paul & Mariotti, Thomas & Rochet, Jean-Charles & Villeneuve, Stéphane, 2008. "Free Cash-Flow, Issuance Costs and Stock Price Volatility," IDEI Working Papers 518, Institut d'Économie Industrielle (IDEI), Toulouse. [Downloadable!]
  7. Hisashi Nakamura, 2007. "Strategic Default Jump as Impulse Control in Continuous Time," CIRJE F-Series CIRJE-F-532, CIRJE, Faculty of Economics, University of Tokyo. [Downloadable!]
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