Optimal contracts with hidden risk

Rui Li and Noah Williams
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Rui Li: University of Massachusetts Boston

Review of Economic Dynamics, 2025, vol. 58

Abstract: Recent years have seen episodes of managers subjecting firms to large losses. We develop a dynamic moral hazard model where a manager may divert funds, and also take actions yielding current payoffs, but increasing risks of losses. We show that pay-for-performance contracts exacerbate the risk management friction, then characterize the optimal risk management contract. We solve two examples. One is explicitly solvable, and the optimal contract can be implemented with simple instruments including “clawback†of promised bonuses. The second example shows that it may be optimal for the owner to forgo risk management, allowing the manager to take excess risk. (Copyright: Elsevier)

Date: 2025
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DOI: 10.1016/j.red.2025.101306

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