Robust Contracts in Continuous Time

Jianjun Miao and Alejandro Rivera

Econometrica, 2016, vol. 84, issue 4, 1405-1440

Abstract: We study a continuous‐time contracting problem under hidden action, where the principal has ambiguous beliefs about the project cash flows. The principal designs a robust contract that maximizes his utility under the worst‐case scenario subject to the agent's incentive and participation constraints. Robustness generates endogenous belief heterogeneity and induces a tradeoff between incentives and ambiguity sharing so that the incentive constraint does not always bind. We implement the optimal contract by cash reserves, debt, and equity. In addition to receiving ordinary dividends when cash reserves reach a threshold, outside equity holders also receive special dividends or inject cash in the cash reserves to hedge against model uncertainty and smooth dividends. The equity premium and the credit yield spread generated by ambiguity aversion are state dependent and high for distressed firms with low cash reserves.

Date: 2016
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Citations: View citations in EconPapers (43)

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https://doi.org/10.3982/ECTA13127

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Journal Article: Robust Contracts in Continuous Time (2016)
Working Paper: Robust Contracts in Continuous Time (2013)
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