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Optimal compensation with adverse selection and dynamic actions

Cvitanić, Jakša and Zhang, Jianfeng (2007) Optimal compensation with adverse selection and dynamic actions. Mathematics and Financial Economics, 1 (1). pp. 21-55. ISSN 1862-9679. doi:10.1007/s11579-007-0002-2.

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We consider continuous-time models in which the agent is paid at the end of the time horizon by the principal, who does not know the agent’s type. The agent dynamically affects either the drift of the underlying output process, or its volatility. The principal’s problem reduces to a calculus of variation problem for the agent’s level of utility. The optimal ratio of marginal utilities is random, via dependence on the underlying output process. When the agent affects the drift only, in the risk- neutral case lower volatility corresponds to the more incentive optimal contract for the smaller range of agents who get rent above the reservation utility. If only the volatility is affected, the optimal contract is necessarily non-incentive, unlike in the first-best case. We also suggest a procedure for finding simple and reasonable contracts, which, however, are not necessarily optimal.

Item Type:Article
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URLURL TypeDescription ReadCube access
Cvitanić, Jakša0000-0001-6651-3552
Additional Information:© Springer-Verlag 2007. Received: 1 August 2006 / Accepted: 24 January 2007 / Published online: 16 March 2007. Research supported in part by NSF grants DMS 04-03575 and 06-31298. We would like to express our gratitude to participants of the following seminars and conferences for useful comments and suggestions: UCLA (Econ Theory), Caltech (Econ Theory), Columbia (Probability), Princeton (Fin. Engineering), U. Texas at Austin (Math Finance), Banff Workshop on Optim. Problems in Fin. Econ, Kyoto U. (Economics), UC Irvine (Probability), Cornell (Fin. Engineering), Bachelier Seminar. Moreover, we are very grateful to the anonymous referee for helpful suggestions. The remaining errors are the authors’ sole responsibility.
Funding AgencyGrant Number
NSFDMS 04-03575
NSFDMS 06-31298
Subject Keywords:Adverse selection; Moral hazard; Principal-agent problems; Continuous-time models; Contracts; Managers compensation
Issue or Number:1
Classification Code:JEL Classification: C61 C73 D82 J33 M52. Mathematics Subject Classification (2000): 91B28 93E20
Record Number:CaltechAUTHORS:20190828-102317415
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Official Citation:Cvitanić, J. & Zhang, J. Math Finan Econ (2007) 1: 21.
Usage Policy:No commercial reproduction, distribution, display or performance rights in this work are provided.
ID Code:98296
Deposited By: George Porter
Deposited On:28 Aug 2019 20:21
Last Modified:16 Nov 2021 17:38

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