Optimal contracts in continuous-time models

Optimal contracts in continuous-time models

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Article ID: iaor20084531
Country: United States
Volume: 2006
Issue: 95203
Start Page Number: 1
End Page Number: 27
Publication Date: Jan 2006
Journal: Journal of Applied Mathematics and Stochastic Analysis
Authors: , ,
Keywords: stochastic processes, financial
Abstract:

We present a unified approach to solving contracting problems with full information in models driven by Brownian motion. We apply the stochastic maximum principle to give necessary and sufficient conditions for contracts that implement the so-called first-best solution. The optimal contract is proportional to the difference between the underlying process controlled by the agent and a stochastic, state-contingent benchmark. Our methodology covers a number of frameworks considered in the existing literature. The main finance applications of this theory are optimal compensation of company executives and of portfolio managers.

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