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Contracting with Risk Aversion and Subjective Beliefs Under Costly State Verification

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  • 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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  1. Harold L Cole & Narayana Kocherlakota, 2010. "Efficient Allocations with Hidden Income and Hidden Storage," Levine's Working Paper Archive 1909, David K. Levine.
  2. 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.
  3. Mordecai Kurz, 2001. "Heterogenous Forecasting and Federal Reserve Information," Working Papers 02002, Stanford University, Department of Economics.
  4. Ben Bernanke & Mark Gertler & Simon Gilchrist, 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," NBER Working Papers 6455, National Bureau of Economic Research, Inc.
  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.
  6. Atkeson, Andrew & Lucas, Robert E, Jr, 1992. "On Efficient Distribution with Private Information," Review of Economic Studies, Wiley Blackwell, vol. 59(3), pages 427-53, July.
  7. Gaia Garino & Peter Simmons, . "A Note on Costly State Observation Contracts with Risk Aversion," Discussion Papers 95/24, Department of Economics, University of York.
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