Contracting with Risk Aversion and Subjective Beliefs Under Costly State Verification

Carsten Nielsen and Mordecai Kurz

No 615, Econometric Society 2004 Far Eastern Meetings from Econometric Society

Abstract: We study the loan contracing problem of Gale and Hellwig (1985) under general assumptions of risk aversion and possibly diverse subjective beliefs of the borrower and lender about the income of the investment. We characterize the optimal contract and show that (i) the contractual payoff in verification states varies by states in accord with risk aversion and probability belief of the borrower and lender, and (ii) teh verification region may consist of many intervals. Under these general assumptions, verification states are not necessarily interpreted as "default" states. Rather, they also reflect the need of the parties to trade on their differences in probability in the absence of markets for contingent claims

Keywords: Financial contract; costly state verification; risk aversion; subjective expectations (search for similar items in EconPapers)
JEL-codes: D82 D84 (search for similar items in EconPapers)
Date: 2004-08-11
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