Leverage and Risk Taking

Santiago Moreno-Bromberg and Guillaume Roger
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Santiago Moreno-Bromberg: University of Zurich - Department of Banking and Finance

No 15-49, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We study a continuous time contracting problem with risk taking in which size plays a role. The agent may take on excessive risk to enhance short-term gains; doing so exposes the principal to large, infrequent (poisson) losses. The optimal contract must use size as an instrument; there is downsizing along the equilibrium path to preserve incentive compatibility. We characterize the value function, present properties of the optimal contract and derive stark comparative statics. The contract is implemented using the full array of financial securities (equity, debt, covenants), or as a regulation contract specifying a leverage ratio. We price these securities and show that holding equity is essential to curb risk taking. Firms that are less prone to risk taking can afford a higher leverage. This work is, therefore, particularly pertinent to leverage regulation.

Keywords: asymmetric information; dynamic contracts; moral hazard; risk taking (search for similar items in EconPapers)
JEL-codes: D82 D86 G28 L43 (search for similar items in EconPapers)
Pages: 46 pages
Date: 2015-12, Revised 2016-02
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Citations: View citations in EconPapers (2)

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Related works:
Working Paper: Leverage and Risk Taking (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1549

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