By Ryan Westphal

This paper proposes a model describing the incentive issues faced by principals and agents when the agent has limited liability and is capable of undertaking unidentifiable, inefficient risky behavior. We propose a contract structure by which the principal deters risk by deferring payment to the agent until she reaches an absorbing steady-state in which promised equity alone deters inefficient behavior. The paper discusses the effect of exogenous parameters on the tradeoffs facing the principal as well as the implications they have on the efficient choice of contract. We also outline extensions to the model in which the principal has access to a costly monitoring technology to identify inefficient risk taking. The theoretical results have implications for real-world employment contracts and practices in financial firms such as investment banks and private equity funds.

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Advisor: Curtis Taylor | JEL Codes: D82, D86, G32, L14 | Tagged: Contract Theory, Moral Hazard., Optimal Contracts, Risk Management