Dynamic Security Design

We analyze dynamic financial contracting under moral hazard. The ability to rely on future rewards relaxes the tension between incentive and participation constraints relative to the static case. Entrepreneurs are incited to effort by the promise of future payments after several successes and the threat of liquidation after several failures. The more severe the moral hazard problem, the greater the liquidation risk. The optimal contract can be implemented by holding cash reserves and issuing debt and equity. The firm is liquidated when it runs out of cash. Dividends are paid only when accumulated earnings reach a certain threshold. In the continuous-time limit of the model, stock prices follow a diffusion process, with a stochastic volatility that increases after price drops. In line with empirical findings, performance shocks induce long lasting changes in leverage