University of New South Wales

Choosing Risky Investments with Optimal Credit Contracts

Email address: B.Schworm@unsw.edu.au

Abstract:
We investigate the choice among investment projects by a risk-averse entrepreneur who must borrow funds from a risk-neutral investor who is unable to observe the entrepreneur's choice of investment project and the realised return. There is a public signal, however, that is correlated with the return of the investment. In designing an optimal credit contract, the investor specifies repayments contingent on the observed signal. We focus on the conflict between risk-sharing and incentives in designing the optimal loan contract and its influence on the choice of investment project. To understand the implications of the asymmetric information, we study a benchmark case in which the investor can observe the entrepreneur's choice of project but cannot observe the realised profit. In this case, the investor can induce the right project selection by a forcing contract and the loan contract will provide maximal insurance to the entrepreneur. Turning to the case in which the investor cannot observe the project choice, we derive two possible outcomes based on the equilibrium in the benchmark case. If the investor wants to induce a risky investment, then incentive constraints are not binding and maximal insurance will be provided to the entrepreneur. But if the the investor wants to induce a safe investment, the investor may need to prevent the entrepreneur from choosing the risky investment by forcing him to bear extra risk. The inability of the investor to observe the project choice causes the risky investment to be chosen more often. This counter-intuitive result is caused by the ambiguity in the concept of safe and risky investments when insurance is provided by the loan contract. We demonstrate that the incentive compatibility conditions may change the ordering of investments by risk.

PDF file of paper: Not available.

Session: Economic Theory

Time: Friday, 6 July, 8:45am - 10:15am

Room: D