Abstract
In a two-period model of costly state verification, the optimal contract is characterized and shown to exist. The optimal contract is interpreted as a bond contract. The model extends the result of one-period models that the verification region must be a left-tail interval to a multi-period setting. Conditions are identified for the optimal contract to exhibit features such as call (prepayment) option, coupon payment, or sinking fund. The optimality of certain bond covenants such as “refinancing covenants” and “dividends covenants” is also studied.
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