Security Design and Corporate Governance when Financial Markets are Incomplete
Date Issued
2007
Date
2007
Author(s)
Yi-Hsuan Lin
DOI
en-US
Abstract
We consider a firm facing the managerial moral hazard problem and an
incomplete contract constraint. In the absence of securities markets, as in
Dewatripont and Tirole (1994, QJE), the firm optimally chooses a managerial
compensation scheme and designs a set of corporate securities and financial
contracts which specify the investors’ and the manager’s payoffs as functions of
short-term and long-term earnings, and also a contingent allocation of control
right among investors. In the presence of securities markets, however, we
show that the firm’s governance structure must be biased to reconcile with its
concerns of offering risk sharing to public investors. In particular, depending
on the nature of the security demand, a risky or a riskless security should be optimally issued, which calls for an alteration in both the firm’s optimal
capital structure and the optimal managerial compensation scheme. More
precisely, we obtain the following results. (i) When the demand for corporate
securities is mainly motivated by the need of hedging future endowment risk
(referred to as the hedging demand), the firm may bias its financing decision
toward borrowing less (compared to the case where securities markets do not
exist); and when the demand for corporate securities is mainly motivated by
the need of smoothing life-time consumption (referred to as the consumption
demand), the firm may instead bias its financing decision toward borrowing
more. (ii) When the security design is driven by the hedging demand, and
when the intensity of the hedging demand is positively correlated with the
firm’s short-term earnings, the firm may benefit from replacing the explicit
managerial compensation by indulging the informed manager’s insider trading
activity, which yields an implicit profit to the manager. (iii) In the absence of
securities markets, the explicit managerial compensation does not vary with
the firm quality; in the presence of securities markets, the explicit managerial
compensation as a function of firm quality exhibits a U-shape pattern, with
the lowest managerial salary appearing at a mediocre firm. (iv) When the
security design is driven by the hedging demand, a firm whose systematic risk
and the business cycle are positively correlated tends to benefit from going
public following a boom more than its counterpart whose systematic risk is
negatively correlated with the business cycle.
Subjects
證券設計
公司治理
security design
corporate governance
insider trading
managerial contract
financial contract
capital structure
Type
thesis
File(s)![Thumbnail Image]()
Loading...
Name
ntu-96-R94723059-1.pdf
Size
23.31 KB
Format
Adobe PDF
Checksum
(MD5):fb1781476a7f1b9a6408508af464126b