Moral Hazard in Dynamic Risk Management

Jakša Cvitanić (), Dylan Possamaï () and Nizar Touzi ()
Additional contact information
Jakša Cvitanić: Humanities and Social Sciences, California Institute of Technology, Pasadena, California 91125
Dylan Possamaï: CEREMADE, University Paris-Dauphine, 75116 Paris, France
Nizar Touzi: CMAP, Ecole Polytechnique, 91128 Palaiseau, France

Management Science, 2017, vol. 63, issue 10, 3328-3346

Abstract: We consider a contracting problem in which a principal hires an agent to manage a risky project. When the agent chooses volatility components of the output process and the principal observes the output continuously, the principal can compute the quadratic variation of the output, but not the individual components. This leads to moral hazard with respect to the risk choices of the agent. To find the optimal contract, we develop a novel approach to solving principal–agent problems: first, we identify a family of admissible contracts for which the optimal agent’s action is explicitly characterized; then, we show that we do not lose on generality when finding the optimal contract inside this family, up to integrability conditions. To do this, we use the recent theory of singular changes of measures for Itô processes. We solve the problem in the case of CARA preferences and show that the optimal contract is linear in these factors: the contractible sources of risk, including the output, the quadratic variation of the output and the cross-variations between the output and the contractible risk sources. Thus, like sample Sharpe ratios used in practice, path-dependent contracts naturally arise when there is moral hazard with respect to risk management. In a numerical example, we show that the loss of efficiency can be significant if the principal does not use the quadratic variation component of the optimal contract.

Keywords: principal–agent problem; moral hazard; risk-management; volatility/portfolio selection (search for similar items in EconPapers)
Date: 2017
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (19)

Downloads: (external link)
https://doi.org/10.1287/mnsc.2016.2493 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:63:y:2017:i:10:p:3328-3346

Access Statistics for this article

More articles in Management Science from INFORMS Contact information at EDIRC.
Bibliographic data for series maintained by Chris Asher ().