Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications

Bruno Biais, Thomas Mariotti, Guillaume Plantin () and Jean Rochet
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Thomas Mariotti: TSE-R - Toulouse School of Economics - UT Capitole - Université Toulouse Capitole - UT - Université de Toulouse - INRA - Institut National de la Recherche Agronomique - EHESS - École des hautes études en sciences sociales - CNRS - Centre National de la Recherche Scientifique
Guillaume Plantin: London Business School, Tepper School of Business - CMU - Carnegie Mellon University [Pittsburgh]

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Abstract: An entrepreneur with limited liability needs to finance an infinite horizon investment project. An agency problem arises because she can divert operating cash flows before reporting them to the financiers. We first study the optimal contract in discrete time. This contract can be implemented by cash reserves, debt, and equity. The latter is split between the financiers and the entrepreneur and pays dividends when retained earnings reach a threshold. To provide appropriate incentives to the entrepreneur, the firm is downsized when it runs short of cash. We then study the continuous-time limit of the model. We prove the convergence of the discrete-time value functions and optimal contracts. Our analysis yields rich implications for the dynamics of security prices. Stock prices follow a diffusion reflected at the dividend barrier and absorbed at 0. Their volatility, as well as the leverage ratio of the firm, increase after bad performance. Stock prices and book-to-market ratios are in a non-monotonic relationship. A more severe agency problem entails lower price-earning ratios and firm liquidity and higher default risk.

Date: 2007-04
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Citations: View citations in EconPapers (163)

Published in Review of Economic Studies, 2007, 74 (2), pp.345 - 390. ⟨10.1111/j.1467-937X.2007.00425.x⟩

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Journal Article: Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications (2007)
Working Paper: Dynamic Security Design: Convergence to Continuous Time and Asset Pricing Implications (2006)
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Persistent link: https://EconPapers.repec.org/RePEc:hal:journl:hal-03415915

DOI: 10.1111/j.1467-937X.2007.00425.x

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