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RFS Advance Access published online on May 25, 2005
Review of Financial Studies, doi:10.1093/rfs/hhi020
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© The Author 2005. Published by Oxford University Press. All rights reserved. For Permissions, please email: journals.permissions@oupjournals.org
Received August 13, 2004

Article

Optimal Contracts under Adverse Selection and Moral Hazard: a Continuous-Time Approach

Jaeyoung Sung 1*
1 Department of Finance (M/C 168), University of Illinois at Chicago, 601 South Morgan Street, Chicago, Illinois 60607-7124

* To whom correspondence should be addressed.
Jaeyoung Sung, E-mail: jsung{at}uic.edu


  Abstract

This paper presents a continuous-time agency model in the presence of adverse selection and moral hazard with a risk-averse agent and a risk-neutral principal. Under the model setup, we show that the optimal controls are constant over time and thus the optimal menu consists of contracts that are linear in the final outcome. We also show that when a moral hazard problem adds to an adverse selection problem, the monotonicity condition well-known in the pure adverse selection literature needs to be modified in order to ensure the incentive compatibility for information revelation. The model is applied to a few managerial compensation problems involving managerial project selection and capital budgeting decisions. We argue that in the third-best world, the relationship between the volatility of the outcome and the sensitivity of the contract depends on interactions between the managerial cost and the firm’s production functions. Contrary to conventional wisdom, sometimes the higher the volatility, the higher the sensitivity of the contract. The firm receiving good news sometimes chooses safer projects or invests less than it does with bad news. We also examine the effects of the observability of the volatility on corporate investment decisions.

Keywords: optimal contracts, principal-agent problems, moral hazard, adverse selection, stochastic control, executive compensation, capital budgeting.
*I am grateful to Michael Fishman (the editor), Mark Loewenstein, Heinz Schättler, and the two anonymous referees for many helpful comments and suggestions. I am particularly grateful to the editor and the referees who provided numerous insightful comments which led to a significant improvement of the paper. Of course, all remaining errors are mine. Earlier versions of this paper were presented at the UIC, Boston University, the 2001 Com2Mac Mathematical Finance Workshop, Korea, the 2001 Far Eastern Econometric Society, Japan, the 2001 EFA, Spain, and the 2002 KAFA/KFA, Korea.
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