Dynamic relational contracts under complete information

Abstract

This paper considers a long-term relationship between two agents who both undertake an action or investment that produces a joint benefit. Agents have an opportunity to expropriate some of the joint benefit for their own use. Agents have quasi-linear preferences. Two cases are considered: where agents are risk averse but where limited liability constraints do not bind, and where agents are risk neutral and subject to limited liability constraints. We ask how to structure the investments and division of the surplus over time to avoid expropriation. In the risk-averse case, the dynamics of actions and surplus may or may not be monotonic depending on whether or not a first-best allocation can be sustained. Agents may underinvest but never overinvest. If the first-best allocation is not sustainable, there is a trade-off between risk sharing and surplus maximization; surplus may not be at its constrained maximum even in the long run and the "amnesia" property of pure risk-sharing models fails to hold. In contrast, in the risk-neutral case there may be an initial phase in which one agent overinvests and the other underinvests. Both actions and surplus converge monotonically to a stationary state, where surplus is maximized subject to the self-enforcing constraints.

The q-factor model and the redundancy of the value factor: An application to hedge funds

“…Hedge funds are thus in line with the Fama and French's (2015) new puzzle related to portfolios of small stocks whose returns behave like of firms that invest a lot despite low profitability. However, according to the theory of implicit contracts in economics, firms may overinvest to relax their financing constraints 5 (e.g., Fazarri et al, 1988;Thomas and Worrall, 2014). In this respect, the fivefactor model does not mitigate the hedge funds' alpha puzzle: the alpha is insensitive to the two new factors.…”

Theq-factor and the Fama and French asset pricing models: hedge fund evidence

“…More precisely, they hope to generate enough positive cash-flows with their investments to relax their financial constraints (e.g. Fazzari et al, 1988;Thomas and Worrall, 2014).…”

Renegotiation of long‐term contracts as part of an implicit agreement

“…In comparison, I consider arbitrary long‐term contracts that can be renegotiated (as previously discussed, this is also done in WMO). In addition, I contribute to the comparatively smaller literature on relational contracts with risk aversion (Thomas and Worrall (1988), Pearce and Stacchetti (1998), MacLeod (2003), Thomas and Worrall (2018)).…”