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Equity, Options and Efficiency in the Presence of Moral Hazard

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  • Michael Magill

    (University of Southern California)

Abstract

This paper provides a general equilibrium analysis of an economy with production under uncertainty in which the firms' capital (ownership) structure creates a moral hazard problem for their managers. The paper studies the concept of an equilibrium with rational, competitive price perceptions (RCPP) in which investors correctly anticipate the optimal effort of entrepreneurs by observing their financial decisions, and entrepreneurs are aware that investors use their financial decisions as signals. The competitive element in the equilibrium valuation of firms comes from the fact that entrepreneurs cannot affect the market price of risks. It is shown that under appropriate spanning assumptions an RCPP is constrained Pareto optimal. Furthermore, if sufficiently many options are traded, then full optimality can be obtained despite the moral hazard problem: options serve both to increase the span of the market and to provide incentives for entrepreneurs.

Suggested Citation

  • Michael Magill, 2000. "Equity, Options and Efficiency in the Presence of Moral Hazard," Econometric Society World Congress 2000 Contributed Papers 1845, Econometric Society.
    • Handle: RePEc:ecm:wc2000:1845
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    References listed on IDEAS

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    Cited by:

    1. Bel? Jerez, 2000. "General Equilibrium with Asymmetric Information: a Dual Approach," UFAE and IAE Working Papers 510.02, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC).
    2. Alessandro Citanna & Archishman Chakraborty, 1999. "Moral Hazard, Aggregate Risk and Nominal, Linear Financial Contracts," Working Papers hal-00599915, HAL.
    3. Peter Bossaerts & Caroline Fohlin, 2000. "Universal Banking and the Pricing of Securities Risk: Historical Evidence from Germany," Econometric Society World Congress 2000 Contributed Papers 1596, Econometric Society.

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