Incomplete Contracts and Security Design

Abstract

The analysis of financial contracts subject to credit risk has received much attention in modern financial theory. Two approaches have dominated this analysis: contingent claims analysis and agency theory. The popularity of the first approach owes much to the pioneering work of Black & Scholes (1973) and of Merton (1973) and was first applied to the valuation of risky debt contracts by Merton (1974). Contingent claims analysis is used to value risky claims whose value depends on one or more variables which are assumed to follow a certain exogenous stochastic process. It can be applied if the stochastic variables are contractible in the sense that they are observable to all parties in a contractual relationship and verifiable to outsiders. This is not a realistic assumption in many situations, where the actions of one party are not observable to others (hidden action) or where the type of counterparty is not known to others (hidden information). Agency theory deals with these types of problems where contracts must provide incentives to reduce inefficiency. The application of agency theory to financial contracting has been significantly advanced by the work of Jensen & Meckling (1976).