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Contracting with Risk Aversion and Subjective Beliefs Under Costly State Verification

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Author Info
Carsten Krabbe Nielsen
Mordecai Kurz
Abstract

We study the loan contracing problem of Gale and Hellwig (1985) under general assumptions of risk aversion and possibly diverse subjective beliefs of the borrower and lender about the income of the investment. We characterize the optimal contract and show that (i) the contractual payoff in verification states varies by states in accord with risk aversion and probability belief of the borrower and lender, and (ii) teh verification region may consist of many intervals. Under these general assumptions, verification states are not necessarily interpreted as "default" states. Rather, they also reflect the need of the parties to trade on their differences in probability in the absence of markets for contingent claims

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Paper provided by Econometric Society in its series Econometric Society 2004 Far Eastern Meetings with number 615.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:feam04:615

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Keywords: Financial contract; costly state verification; risk aversion; subjective expectations;

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Find related papers by JEL classification:
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations

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  1. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier. [Downloadable!] (restricted)
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  2. Harold L. Cole & Narayana R. Kocherlakota, 1999. "Efficient allocations with hidden income and hidden storage," Staff Report 238, Federal Reserve Bank of Minneapolis. [Downloadable!]
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  3. Mordecai Kurz, 2001. "Heterogenous Forecasting and Federal Reserve Information," Working Papers 02002, Stanford University, Department of Economics. [Downloadable!]
  4. Atkeson, Andrew & Lucas, Robert E, Jr, 1992. "On Efficient Distribution with Private Information," Review of Economic Studies, Blackwell Publishing, vol. 59(3), pages 427-53, July. [Downloadable!] (restricted)
  5. Innes, Robert D., 1990. "Limited liability and incentive contracting with ex-ante action choices," Journal of Economic Theory, Elsevier, vol. 52(1), pages 45-67, October. [Downloadable!] (restricted)
  6. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October. [Downloadable!] (restricted)
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