Econometrica: Jul 2016, Volume 84, Issue 4

Robust Contracts in Continuous Time

https://doi.org/10.3982/ECTA13127
p. 1405-1440

Jianjun Miao, Alejandro Rivera

We study a continuous‐time contracting problem under hidden action, where the principal has ambiguous beliefs about the project cash flows. The principal designs a robust contract that maximizes his utility under the worst‐case scenario subject to the agent's incentive and participation constraints. Robustness generates endogenous belief heterogeneity and induces a tradeoff between incentives and ambiguity sharing so that the incentive constraint does not always bind. We implement the optimal contract by cash reserves, debt, and equity. In addition to receiving ordinary dividends when cash reserves reach a threshold, outside equity holders also receive special dividends or inject cash in the cash reserves to hedge against model uncertainty and smooth dividends. The equity premium and the credit yield spread generated by ambiguity aversion are state dependent and high for distressed firms with low cash reserves.

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Supplemental Material

Supplement to "Robust Contracts in Continuous Time"

This appendix consists of two sections. In Section A we adopt the Chen-Epstein (2002) recursive multiple-priors utility model to study the robust contracting problem.  We compare this case with the robust contracting problem studied in the paper.  In Section B we study a model with risk aversion only and compare the solution with our robust contracting solution.  We also establish some observational equivalence results.

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