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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

Suggested Citation

  • Carsten Krabbe Nielsen & Mordecai Kurz, 2004. "Contracting with Risk Aversion and Subjective Beliefs Under Costly State Verification," Econometric Society 2004 Far Eastern Meetings 615, Econometric Society.
    • Handle: RePEc:ecm:feam04:615
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    References listed on IDEAS

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    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.
    7. Mordecai Kurz, 2001. "Heterogenous Forecasting and Federal Reserve Information," Working Papers 02002, Stanford University, Department of Economics.
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    More about this item

    Keywords

    Financial contract; costly state verification; risk aversion; subjective expectations;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations

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