Corporate Risk Management

CHAPTER 10Optimal Financial Contracts and Incentives under Moral Hazard

Up to now, we have focused on the analysis of managers' actions that can reduce the dispersion of distributions of random variables.¹ These actions, which affect the volatility of results, are called second-order actions because they affect only the moments of distributions greater than one, which are mainly limited to variance.

The means of distributions are notably affected by risk management actions that introduce first-order variations of distributions (Courbage, Rey, and Treich, 2013; Winter, 2013). They are generally associated with loss prevention, self-protection, precaution, or efforts to obtain higher profits or lower losses. Many of these actions do not involve the use of financial instruments.

Obviously, entrepreneurs who finance 100% of a project have very strong incentives to maximize the expected profits and to reduce the default probability. In contrast, when a project is financed by third parties with partial guarantees, incentives may be weaker, particularly when the managers' actions are not perfectly observable by creditors. This incentive problem is called ex ante moral hazard. Moral hazard is present when the prevention actions of one party (business, individual, worker, or agent) are not observable by another party associated with the risks of a contract (bank, insurance company, employer, or principal), but may suffer the financial consequences associated with these risks. Moral ...