Debt, Futures and Options: Optimal Price-Linked Financial Contracts under Moral Hazard and Limited Liability

Abstract

This paper characterizes the optimal financial contract between a risk neutral entrepreneur and risk neutral lender/investors when the entrepreneur has limited liability, there is moral hazard, and the investor payoff function can depend on both output and output price but is nondecreasing in output. In this setting, the optimal contract is a price-contingent commodity bond that can be replicated by combining pure debt, commodity futures, and commodity call option contracts. Although a pure commodity bond contract is sometimes optimal, a pure debt contract is almost never optimal. Various properties of the entrepreneur's optimal price-contingent promised payment are described. Copyright 1993 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

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