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Leverage and Risk Taking

Author

Listed:
  • Santiago Moreno-Bromberg

    (University of Zurich - Department of Banking and Finance)

  • Guillaume Roger

    (The University of Sydney - School of Economics)

Abstract

We study a continuous time contracting problem with risk taking in which size plays a role. The agent may take on excessive risk to enhance short-term gains; doing so exposes the principal to large, infrequent (poisson) losses. The optimal contract must use size as an instrument; there is downsizing along the equilibrium path to preserve incentive compatibility. We characterize the value function, present properties of the optimal contract and derive stark comparative statics. The contract is implemented using the full array of financial securities (equity, debt, covenants), or as a regulation contract specifying a leverage ratio. We price these securities and show that holding equity is essential to curb risk taking. Firms that are less prone to risk taking can afford a higher leverage. This work is, therefore, particularly pertinent to leverage regulation.

Suggested Citation

  • Santiago Moreno-Bromberg & Guillaume Roger, 2015. "Leverage and Risk Taking," Swiss Finance Institute Research Paper Series 15-49, Swiss Finance Institute, revised Feb 2016.
    • Handle: RePEc:chf:rpseri:rp1549
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    Cited by:

    1. Felix Feng, 2018. "Dynamic Compensation under Uncertainty Shocks and Limited Commitment," 2018 Meeting Papers 159, Society for Economic Dynamics.
    2. Tak-Yuen Wong, 2019. "Dynamic Agency and Endogenous Risk-Taking," Management Science, INFORMS, vol. 65(9), pages 4032-4048, September.

    More about this item

    Keywords

    asymmetric information; dynamic contracts; moral hazard; risk taking;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • L43 - Industrial Organization - - Antitrust Issues and Policies - - - Legal Monopolies and Regulation or Deregulation

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