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Wealth Contraints and Option Contracts in Models with Sequential Investments

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  • Christoph Lulfesmann

    (Simon Fraser University)

Abstract

I investigate a model in which two parties A and B invest sequentially in a joint project (an asset). Investments and the asset value are nonverifiable, and A is wealth-constrained so that an initial outlay must be financed by either an agent, B (insider financing), or an external investor, a bank C (outsider financing). I show that an option contract in combination with a loan arrangement facilitates first-best investments and any arbitrary distribution of surplus if renegotiation is infeasible. Moreover, the optimal strike price of the option is shown to differ across financing modes. If renegotiation is admitted, I identify conditions under which the first best can still be attained. Then, either B-financing or C-financing may be strictly preferable, and a combination of insider and outsider financing may be strictly optimal.

Suggested Citation

  • Christoph Lulfesmann, 2005. "Wealth Contraints and Option Contracts in Models with Sequential Investments," RAND Journal of Economics, The RAND Corporation, vol. 36(4), pages 753-770, Winter.
    • Handle: RePEc:rje:randje:v:36:y:2005:4:p:753-770
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    Cited by:

    1. Christoph Lülfesmann, 2021. "Strategic Shirking in Bilateral Trade," Scandinavian Journal of Economics, Wiley Blackwell, vol. 123(4), pages 1292-1313, October.

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