A COMMODITY LINKED BOND AS AN OPTIMAL DEBT INSTRUMENT IN THE PRESENCE OF MORAL HAZARD

In this paper we communicate two results. First, we construct an example in which a firm strictly prefers to issue a bond linked to the price of a commodity as opposed to a fixed rate bond. The firm with a fixed rate bond chooses a suboptimal investment policy because the outstanding nominal obligation distorts the incentives of the equity owners. The commodity linked bond resolves this moral hazard problem. Second, we show that in the presence of moral hazard problems the traditional application of contingent claims valuation techniques leads to an incorrect valuation of the the real assets and consequently to an incorrect valuation of the financial liabilities written against those assets. We show how the technique can be adapted to yield correct valuations