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Investor protection and optimal contracts under risk aversion and costly state verification

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  • Cesar Tamayo

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Abstract

We present a model of firm finance that encompasses imperfect investor protection, risk aversion and costly state verification. We characterize optimal contracts and study the conditions under which standard debt is optimal. Under suitable assumptions about the structure of the problem, standard debt contracts (SDCs) are optimal if and only if investor protection is sufficiently low. On the other hand, low investor protection results in higher funding costs and bankruptcy probabilities. In our setting, this implies that when SDCs are optimal, lowering investor protection reduces the entrepreneur’s welfare. Numerical examples show that moderate changes in investor protection can have large effects on the terms of the contract and on the entrepreneur’s welfare. Finally, we study the role of leverage and consider the welfare consequences of suboptimally implementing standard debt contracts. Copyright Springer-Verlag Berlin Heidelberg 2015

Suggested Citation

  • Cesar Tamayo, 2015. "Investor protection and optimal contracts under risk aversion and costly state verification," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 59(3), pages 547-577, August.
  • Handle: RePEc:spr:joecth:v:59:y:2015:i:3:p:547-577
    DOI: 10.1007/s00199-014-0856-5
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    References listed on IDEAS

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    Cited by:

    1. repec:red:issued:16-56 is not listed on IDEAS
    2. Cesar Tamayo, 2017. "Bankruptcy Choice with Endogenous Financial Constraints," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 26, pages 225-242, October.

    More about this item

    Keywords

    Investor protection; Risk aversion; Financial contracts; Standard debt; D86; E61; G10; G18; G38; K40;

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • K40 - Law and Economics - - Legal Procedure, the Legal System, and Illegal Behavior - - - General

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