This paper attemps to rationalize the use of insurance covenants in financial contracts, and shows how external financing generates a demand for insurance by risk-neutral entrepreneurs. In our model, the entrepreneur needs external financing for a risky project that can be affected by an accident during its realization. We derive the optimal financial contract. We then analyse how how this optimal contract can be achieved by decentralized trading on competitive markets when insurance and banking activities are exogenously separated. Finally, we show how are results imply 'induced risk aversion' for risk-neutral firms and we extend the model to property insurance.
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Paper provided by Institut National de la Statistique et des Etudes Economiques- in its series Papers with number
9644.
Length: 34 pages Date of creation: 1996 Date of revision: Handle: RePEc:fth:inseep:9644
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Find related papers by JEL classification: D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies
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