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Dynamic Moral Hazard and Risk-Shifting Incentives in a Leveraged Firm

Published online by Cambridge University Press:  16 October 2019

Alejandro Rivera
Alejandro Rivera*
Affiliation:
Rivera, [email protected], University of Texas at Dallas Department of Finance and Managerial Economics
*
Rivera (corresponding author), [email protected]
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Abstract

I develop an analytically tractable model that integrates the risk-shifting problem between bondholders and shareholders with the moral-hazard problem between shareholders and the manager. An optimal contract binds shareholders and the manager, and this contract’s flexibility allows shareholders to relax the manager’s incentive constraint following a “good” profitability shock. Thus, the optimal contract amplifies the upside and thereby increases shareholder appetite for risk shifting. Whereas some empirical studies find a positive relation between risk shifting and leverage, others find a negative relation. This model predicts a non-monotonic relation between risk shifting and leverage and can reconcile these contradictory empirical findings.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 55 , Issue 4 , June 2020 , pp. 1333 - 1367
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2019

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Footnotes

I am extremely grateful to Simon Gilchrist, Francois Gourio, Dirk Hackbarth, Jianjun Miao, and Berardino Palazzo for their valuable advice and encouragement. I also thank an anonymous referee, Rui Albuquerque, Andrea Buffa, Jerome Detemple, Mehmet Eckmekci (discussant), Stefania Garetto, Sambuddha Ghosh, Adam Guren, Jarrad Harford (the editor), Robert King, Nobuhiro Kiyotaki, Raymond Leung (discussant), Gustavo Manso, Alisdair Mckay, Juan Ortner, Ander Perez, Catalina Rivera, Yuliy Sannikov, Giorgo Sertsios, Enrique Schroth, James Thomson, Laura Veldkamp, Tak Wang, Toni Whited, and seminar participants at Boston University, Bank of Colombia, Federal Reserve Bank of Boston, Federal Reserve Bank of Dallas, Northeastern University, Universidad de los Andes, Universidad Javeriana, Quebec University, City University of London, the 2015 Finance Theory Group Summer School, the 2015 Green Line Macro Meeting Conference, and the 2014 Istanbul Conference of Economics and Finance for very helpful comments.

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