Can Real Options Reduce Moral Hazards in Profit and Loss Sharing Contracts?: A Behavioural Approach Using Game Theory and Agent Based Simulation

Abstract

In this paper, we try reducing the moral hazard of profit misreporting in Profit and Loss Sharing Contract (PLS). In this kind of contracts , the corporate manager has a temptation to misreport profits which can lead to either project failing or to financiers receiving an unfair allocation of profits. To help in solving this problem we propose a new model that includes a real option that gives the corporate manager (agent) the right, but not the obligation, to gradually buy shares in the corporation from the financier/bank. We compare our results with the standard case of PLS without real options. We show, using a multi-agent simulation (Netlogo) that embedding real options in the PLS contract can reduce the profit misreporting case. The fact that PLS contracts are riskier compared to other forms of financing such as debt, provides an incentive for the creation of models that reduce their risk to capital providers. Given the results obtained from our real options model, the latter could prove to be of practical use to financial institutions willing to engage in PLS financing.