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Anticipating Disagreement in Dynamic Contracting
[An incomplete contracts approach to financial contracting]

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  • John Y Zhu

Abstract

This paper studies how anticipated disagreement between a financier and an entrepreneur affects optimal contracting and asset prices. The value of debt is uniquely immune to anticipated disagreement, and when the set of anticipated disagreements is sufficiently rich, this immunity causes the optimal contract to give the financier debt. In contrast, the values of other contracts, including equity, decline as anticipated disagreement becomes more severe. This suggests a channel through which an increase in the severity of anticipated disagreement increases the equity premium and the debt-to-equity ratio.

Suggested Citation

  • John Y Zhu, 2022. "Anticipating Disagreement in Dynamic Contracting [An incomplete contracts approach to financial contracting]," Review of Finance, European Finance Association, vol. 26(5), pages 1241-1265.
    • Handle: RePEc:oup:revfin:v:26:y:2022:i:5:p:1241-1265.
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    File URL: http://hdl.handle.net/10.1093/rof/rfac007
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    References listed on IDEAS

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    More about this item

    Keywords

    Disagreement; Uncertainty; Ambiguity; Robustness; Debt; Overconfidence; Overinvestment; Refinance; Renegotiation; Equity premium; Debt-to-equity ratio; Security design; Financial contracting; Optimal contracting;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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