Optimal Contracting with Effort and Misreporting

Agostino Capponi, Jakša Cvitanic, Türkay Yolcu: We propose a new continuous time contracting model, where the project value process can only be observed with noise, and there are two sources of moral hazard: effort and misreporting.

Author(s):

Agostino Capponi

Purdue University

Jaksa Cvitanic

EDHEC Business School

Turkay Yolcu

Purdue University

Using calculus of variation techniques, we are able to find the optimal pay-per-performance sensitivity (PPS) of the contract offered to the manager, as well as optimal effort and misreporting action via a second order ordinary differential equation with time dependent coefficients. Our findings indicate that the agent will apply a higher level of effort and misreporting than if only one of those actions was present. We numerically illustrate the dependence of the agent’s actions and pay-per-performance sensitivity on the model parameters through a detailed comparative statics analysis. We find that PPS is not necessarily monotone with respect to the variance of observational noise and with respect to time. We also find that the shareholders may care more about motivating the manager to misreport than to apply effort.

Type: Working paper
Date: le 02/11/2011
Research Cluster : Finance

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