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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26451
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| Title: | Security Design with Correlated Hidden Cash Flows:The Optimality of
Performance Pricing |
| Authors: | Tchistyi, Alexei |
| Issue Date: | 3-Oct-2005 |
| Abstract: | This paper studies optimal security design in a dynamic setting with an
agency problem that arises when an agent in charge of a project can
divert cash flows for his own consumption at the expense of an outside
investor. Cash flows are unobservable and unverifiable by the outside
investor, who relies on the agent’s reports, and has the right to
liquidate the project. Unlike previous analyses, we allow cash flows to
be correlated over time. We solve for the optimal contract and show that
it can be implemented using a credit line with an interest rate that
increases with the balance on the credit line. This finding is
consistent with the fact that the majority of commercial loans are lines
of credit with performance pricing. Thus, our model provides theoretical
evidence that performance pricing is used to mitigate the agency cost.
In addition, we develop a new recursive method to deal with a correlated
privately observed variable in dynamic agency settings. It allows us to
reduce the dimensionality of the problem and obtain a closed-form
solution for the optimal contract. |
| URI: | http://hdl.handle.net/2451/26451 |
| Appears in Collections: | Finance Working Papers
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