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Dynamic financial contracting with persistent private information

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  • Shiming Fu
  • R. Vijay Krishna

Abstract

We study a dynamic agency model where the agent privately observes the firm's cash flows that are subject to persistent shocks. We characterize the policy dynamics and implement the optimal contract by financial securities. Because bad performance distorts investors' beliefs downward, the agent has less incentive to misrepresent information. The agent's compensation is less than what he can divert and is convex in performance. As private information becomes more persistent, (i) the agent is compensated more by stock options; (ii) firm credit limits vary more with history, dropping after bad performance; (iii) the firm is financially constrained for longer time.

Suggested Citation

  • Shiming Fu & R. Vijay Krishna, 2019. "Dynamic financial contracting with persistent private information," RAND Journal of Economics, RAND Corporation, vol. 50(2), pages 418-452, June.
    • Handle: RePEc:bla:randje:v:50:y:2019:i:2:p:418-452
    DOI: 10.1111/1756-2171.12275
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    Cited by:

    1. Sandro Brusco & Giuseppe Lopomo & Eva Ropero & Alessandro T. Villa, 2021. "Optimal financial contracting and the effects of firm's size," RAND Journal of Economics, RAND Corporation, vol. 52(2), pages 446-467, June.
    2. Krasikov, Ilia & Lamba, Rohit, 2021. "A theory of dynamic contracting with financial constraints," Journal of Economic Theory, Elsevier, vol. 193(C).
    3. Maideu-Morera, Gerard, 2024. "Firm Size and Compensation Dynamics with Risk Aversion and Persistent Private Information," TSE Working Papers 24-1535, Toulouse School of Economics (TSE).

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