Faculty Digital Archive

Archive@NYU >
Stern School of Business >
Finance Working Papers >

Please use this identifier to cite or link to this item: http://hdl.handle.net/2451/26451

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

Files in This Item:

File Description SizeFormat
FIN-05-043.pdf633.44 kBAdobe PDFView/Open

Items in Faculty Digital Archive are protected by copyright, with all rights reserved, unless otherwise indicated.

 

The contents of the FDA may be subject to copyright, be offered under a Creative Commons license, or be in the public domain.
Please check items for rights statements. For information about NYU’s copyright policy, see http://www.nyu.edu/footer/copyright-and-fair-use.html 
Valid XHTML 1.0 | CSS