Dynamic Moral Hazard and Risk-Shifting Incentives in a Leveraged Firm

54 Pages Posted: 8 Nov 2017 Last revised: 15 Jan 2019

See all articles by Alejandro Rivera

Alejandro Rivera

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics

Date Written: January 14, 2019

Abstract

I develop an analytically tractable model that integrates the risk-shifting problem between bondholders and shareholders with the moral hazard problem between shareholders and the manager. The presence of managerial moral hazard exacerbates the risk-shifting problem. An optimal contract binds shareholders and the manager. The flexibility of this contract allows shareholders to relax the incentive constraint of the manager when a good profitability shock is drawn. Hence, the optimal contract amplifies the upside thereby increasing shareholder appetite for risk-shifting. Moreover, some empirical studies find a positive relation between risk-shifting and leverage, while others studies find a negative relation. The model predicts a non-monotonic relation between risk-shifting and leverage and has the potential to reconcile this empirical evidence.

Keywords: Risk-shifting, Moral Hazard, Principal-Agent Problem

JEL Classification: D86

Suggested Citation

Rivera, Alejandro, Dynamic Moral Hazard and Risk-Shifting Incentives in a Leveraged Firm (January 14, 2019). Available at SSRN: https://ssrn.com/abstract=3066525 or http://dx.doi.org/10.2139/ssrn.3066525

Alejandro Rivera (Contact Author)

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics ( email )

2601 North Floyd Road
P.O. Box 830688
Richardson, TX 75083
United States

HOME PAGE: http://jindal.utdallas.edu/faculty/alejandro-rivera

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