Optimal financial contracts with unobservable investments

Tirelli, Mario (2018): Optimal financial contracts with unobservable investments.

Abstract

In this article we propose a security-design problem in which risk neutral entrepreneurs make unobservable investment decisions while employing the investment funds of risk-neutral outside investor/creditor(s). Contracts are restricted to satisfy limited liability and monotonicity of the payment schedule. The model we present extends the classical one proposed by Innes (1990, Journal of Economic Theory 52, 47-67) along three main directions: agents' decisions may be restricted by their initial capital and outside financial opportunities; their investment decisions may also consist in hiding funds in an asset placed outside their firms; initial firms' capital, which identifies entrepreneur types, may only be imperfectly observed by creditors (i.e. types are private information). We motivate our interest in this security-design problem referring to the 'opacity' that often characterizes the financial situation and decisions of small firms, a particularly large fraction of the non-financial sector in most developed countries.

• Item Type: MPRA Paper
• Language: English
• Keywords: Security design; asymmetric information; moral hazard; investment decisions; firm financial structure; debt contracts, collateral.
• Subjects: D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D82 - Asymmetric and Private Information ; Mechanism Design; D - Microeconomics > D8 - Information, Knowledge, and Uncertainty > D86 - Economics of Contract: Theory; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice ; Investment Decisions; G - Financial Economics > G3 - Corporate Finance and Governance > G32 - Financing Policy ; Financial Risk and Risk Management ; Capital and Ownership Structure ; Value of Firms ; Goodwill

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