Contingent Contracts Research Articles

NUMERICAL PROCEDURES FOR A WRONG WAY RISK MODEL WITH LOGNORMAL HAZARD RATES AND GAUSSIAN INTEREST RATES

In this work, we present some numerical procedures for a wrong way risk model that can be used for credit value adjustment (CVA) calculations. We look at a model that uses a multi-factor Hull–White model for interest rates and a single-factor lognormal Black–Karasinski default intensity model for counterparty credit, where the default intensity driver is correlated with all interest rate drivers. We describe how a trinomial tree-based approach for implementing single factor short rate models by Hull and White (1994) can be modified and used to calibrate the intensity model to credit default swaps (CDSs) in the presence of correlation. We also provide approximate pricing methods for CDS options and single swap contingent CDS contracts. The latter methods could also be used for model calibration purposes subject to data availability.

Hotspot Economics: Procurement of Third-Party WiFi Capacity for Smart Mobile Data Offloading

The unprecedented growth of cellular traffic driven by web surfing, video streaming, and cloud-based services is creating challenges for cellular service providers to fulfill the unmet demand. To minimize congestion costs for under-served demand (e.g., dissatisfied customers, or churn), the service provider is willing to pay WiFi hotspots to serve the demand that exceeds capacity. In the present study, we propose an optimal procurement mechanism with contingent contracts for service providers to leverage the advantages of both cellular and WiFi resources. As compared with conventional cellular communication technologies, WiFi hotspots provide data rates with a limited coverage. Our present work contributes to the existing literature by developing an analytical model, which considers this unique challenge of integrating the longer range cellular resource and shorter range WiFi hotspots. We show the procedure of computing the optimal procurement mechanism with a tight integration of economics and computational technology. The model is validated using cellular network data from a large U.S. service provider. The simulation results show that the proposed procurement mechanism significantly outperforms the standard Vickrey-Clarke-Groves (VCG) auction in terms of the service provider's expected payoff.

Negotiating Out of Holdouts in Land Aggregation in India: Small Town Lawyers, Contingent Contracts, Social Norms, and Auctions

This a paper about the role of lawyers in small towns in India as the intermediary agents of large corporations. They help resolve disputes among farmers with small land holdings and also negotiate with them to purchase and aggregate a valuable asset i.e., land, for these corporations to expand their operations to serve foreign markets or domestic markets that have grown since 1991. Without these small-town lawyers, infrastructure and multinational corporations would likely rely on the government to aggregate small parcels by exercising eminent domain with low “just” compensation, and then face political problems and higher long-run costs. In fact, it is safe to say that without these small-town lawyers, many corporations (including the likes of Infosys, Satyam, GMR, and GVK) would not have amassed and managed their land-banks which are the most valuable assets on their balance sheets. These small town lawyers leverage contingent contracts, and pressures of social norms, social exclusion, and coalition building in their aggregation efforts. There is evidence to show that they are able to offer integrative negotiation solutions to small landowners, thereby producing lesser resentment among them. They are also able to network with small town lawyers in rival locations of aggregation and create competitive auction markets to exert a downward pressure on reservation prices of small landowners.

The Endurance and Eclipse of the Controlled Vote: A Formal Model of Vote Brokerage Under the Secret Ballot

Throughout much of mankind's experience with elections, vote brokers – local elites who direct the voting decisions of a subset of the electorate – have been able to make or break political careers. In various polities, brokers have thrived in spite of the secret ballot, a surprising outcome given that vote secrecy would ostensibly allow citizens to pocket the inducements offered by such individuals and vote their consciences anyway. To address this puzzle, we develop a framework for understanding the persistence and demise of vote brokerage under the secret ballot. In our model, a broker contracts with voters using an outcome contingent contract: some fixed benefit is promised to all voters sharing one of several observable profiles should the broker's candidate win the election. Using this framework, we demonstrate that the existence of brokerage depends on the size of the electorate contained within the jurisdiction controlled by the broker, with large jurisdiction sizes tending to drive brokerage out of existence. Moreover, we detail the manner in which the strategies employed by brokers depend on their economic power, the size of social groups, and ideological polarization. Empirical evidence from Minas Gerais, Brazil is used to evaluate the performance of the model.

Task assignment under agent loss aversion

We analyze a task-assignment model in which a principal assigns a task to one of two agents depending on future states. If the agents have concave utility, the principal assigns the task to them contingent on the state. We show that if the agents are loss averse, a state-independent assignment–assigning the task to a single agent in all states–can be optimal even when the principal can write a contingent contract at no cost.

Game Mining: How to Make Money from Those About to Play a Game

It is known that a player in a noncooperative game can benefit by publicly re- stricting their possible moves before start of play. We show that, more generally, a player may benefit by publicly committing to pay an external party an amount that is contingent on the game's outcome. We explore what happens when external parties (who we call game miners) discover this fact and seek to profit from it by entering an outcome-contingent contract with the players. We analyze various bargaining games between miners and players for determining such an outcome- contingent contract. We establish restrictions on the strategic settings in which a game miner can profit, and bounds on the game miner's profit given various structured bargaining games. These bargaining games include playing the players against one another, as well as allowing the players to pay the miner(s) for exclu- sivity and first-mover advantage. We also establish that when all players can enter contracts with miners, to guarantee the existence of equilibria it is necessary to assume that players can randomize over the contracts they make.

Preventing Banking Crises--with Private Insurance?

In this article, we review the functioning of private insurance against banking crises and identify its potential. The essential idea is that banks are recapitalized by private investors when negative events would otherwise cause a write-down of capital—or even bank insolvency. There are two modes of private insurance: pure insurance contracts and contingent debt contracts. In the former, funding of banks and insurance are separated, whereas in the latter, debt holders provide insurance. We summarize the main insights regarding the potential and limits of private insurance. We also discuss how such crisis insurance could be strengthened through complementary regulatory measures. Finally, we outline the overall pecking order of buffers and insurance for banking systems. (JEL codes: D41, E4, G2)

Buyer Groups, Antitrust and Outsiders

A buyer group is a subset of downstream firms that pool their demand for an upstream input to negotiate a better deal with suppliers. This study develops a simple model that shows how a buyer group changes market behaviour, focusing on the impact on downstream firms outside the buyer group. This impact critically depends on whether or not the buyer group and the supplier can write a contract contingent on the market price paid by outsiders. With contingent contracts, the price paid by firms outside the buyer group rises and their profits fall. If such contracts are infeasible, possibly due to legal concerns, the market price is lower after the buyer group forms. These results raise issues for antitrust authorities in Australia, Europe, the USA and elsewhere who evaluate buyer‐group agreements. We extend the model to consider the situation where a supplier can commit in advance to the market price. In this situation, the bargaining power of the buyer group becomes relevant with the market price inversely related to this bargaining power. We illustrate our results with a simple example.

Avoiding Capability Traps Through Contingent Contracts: The Role of Cash and Knowhow in Startups

The impact of an investor’s cash and knowhow on an entrepreneur’s performance has been debated. Investors may argue that their knowhow can substitute for cash, whereas entrepreneurs view knowhow to...

Avoiding Capability Traps Through Contingent Contracts: The Role of Cash and Knowhow in Startups

The impact of an investor’s cash and knowhow on an entrepreneur’s performance has been debated. Investors may argue that their knowhow can substitute for cash, whereas entrepreneurs view knowhow to be a complement for cash, asking for more knowhow when they seek more cash. We model the impact of cash and knowhow in two-stage contingent contracts, subject to the entrepreneur meeting performance goals at the end of the first stage. Analytical findings are tested using angel investment data. Results reveal a nuanced relationship between cash and knowhow. Increasing the level of knowhow provision in the first stage of the contract makes the investor’s offer more attractive to the entrepreneur. However, contracts for such knowhow can create a capability trap, such that insufficient knowhow transfer results in failure to secure second stage financing. Analyzing contract parameters illustrates a tradeoff between the capability trap risk and the amount of second stage investment.

Capital flows under moral hazard

I analyze a model with moral hazard and limited enforcement in a small open economy. I find that when state contingent contracting is allowed adding the moral hazard friction improves the model's predictions along several dimensions. First, it justifies why non-contingent debt is an optimal way to finance an emerging economy. Second, it explains the limited consumption risk-sharing and high, volatile and counter-cyclical interest rates. Third, it generates realistic crisis-like dynamics in which capital inflows are brought to a halt and interest rates sky-rocket. The model also has a strong internal propagation mechanism.Limited enforcement friction, alone or together with moral hazard, has nearly no effect on the model's performance. I also construct a simple empirical test to distinguish between the two frictions and it favors moral hazard over limited enforcement friction.

Management Insights

Management Insights

Holdout: Existence, Information, and Contingent Contracting

The holdout problem permeates policy discussions of legal issues involving bargaining for land acquisition and more broadly impacts multilateral bargaining between agents. Laboratory experiments investigate the scope of the holdout problem. The research strategy incorporates as treatment variables available information and the exposure problem arising from the unavailability of contingent contracts. An examination reveals that holdout can reliably produce large inefficiencies and lost opportunities for mutually advantageous trade. The introduction of contingent contracts facilitates successful bargaining. However, buyers are not made significantly better off by contingent contracts.

Signaling by an Expert

In this paper, we allow an expert with moral hazard to have private information on what would happen to his client both with his service and without his service. The contingent component in the contract this expert offers helps overcome his moral hazard, but also serves as a signal of his private information. We distinguish two concepts: the value of the service and the service outcome. Focusing on Intuitive-Criterion-satisfying equilibria, we show that the expert’s incentive to signal through the contract influences the contract very differently depending on whether a good service outcome is associated with a high service value or a low service value. In the former case, the contingent fee in any pooling equilibrium is positive and a high-value expert offers a more contingent contract than a low-value expert in any separating equilibrium. In the latter case, under some conditions there exists a pooling equilibrium with both types of experts offering a non-contingent contract and for all separating equilibria a high-value expert offers a less contingent contract than a low-value expert.

Examining the Impact of Anxiety on Contingent Contracting and Bargaining in Negotiations

Contingent contracts have been increasingly important in negotiation research. However, research on the psychological foundation of contingent contracting has been limited. The existing research on...

Manufacturer–Retailer Negotiations in the Presence of an Oligopolistic Input Market

When a manufacturer relies solely on its own inputs in making products, the focus of negotiations between the manufacturer and retailer is exclusively on profits in the output (retail) market. In such cases, absent retail competition concerns, standard two‐part tariff negotiations set the per‐unit wholesale price equal to marginal cost, and require fixed transfers from the retailer to the manufacturer. In this article, we recognize that manufacturers often rely on imperfectly competitive markets for at least some inputs. Incorporating this seemingly natural feature has profound implications for manufacturer–retailer negotiations since it shifts their focus from being exclusively on output markets to one that balances strategic concerns in both input and output realms. The article's main result is that the added need to discipline input prices can lead the manufacturer and retailer to write contingent contracts that are cost‐plus and prescribe lump‐sum slotting allowances (i.e., fixed transfer from the manufacturer to the retailer).

The Impact of Royalty Contract Revision in a Multistage Strategic R&D Alliance

This paper investigates the impact of royalty revision on incentives and profits in a two-stage (research and development (R&D) stage and marketing stage) alliance with a marketer and an innovator. The marketer offers royalty contracts to the innovator. We find that the potential for royalty revision leads to more severe distortions in the optimal initial royalty contracts offered by the marketer. We show that if the innovator plays a significant role in the marketing stage, the marketer should offer a low royalty rate initially and then revise the royalty rate up later. Otherwise, she should do the opposite. We identify two major effects of royalty revision. First, royalty revision provides the marketer with a flexibility to dynamically adjust royalty rates across the two stages of the alliance to better align the innovator's incentives. This incentive-realigning effect improves the marketer's profit. Second, royalty revision makes it harder for the marketer to obtain private information from the innovator, because the innovator worries that the marketer will take advantage of the information to revise the initial contract to a more favorable one to herself later. This information-revealing effect hurts the marketer's profit. We characterize in what kind of alliances marketers would benefit the most from royalty revision so that managers should clearly establish the expectation for royalty revision, and in what kind of alliances markerters would not benefit from royalty revision so that managers should commit not to revise the initial royalty contract. With royalty contracts that are contingent on the R&D outcome of the R&D stage, we find that contingent contract structure could be either substitutable (by fully capturing the incentive re-aligning effect) or complementary (by weakening the information revealing effect) to royalty revision, depending on whether the innovator plays a significant role in the marketing stage. Managers may need to use a contingent contract (if possible) either to replace or with royalty revision accordingly to improve profits. This paper was accepted by Kamalini Ramdas, entrepreneurship and innovation.

On the Benefits and Costs of Legal Expertise: Adjudication in Ancient Athens

Legal expertise permits detailed laws to be written and enforced, but individuals with expertise may employ their special knowledge to skew decisions in privately beneficial directions. We illustrate this tradeoff in a simple model, which we use to guide our analysis of the legal system in ancient Athens. Rather than accepting the costs of expertise in return for the benefits, as do most modern societies, the Athenians designed a legal system that banned professional legal experts. And this was not because Athenian society was simple: The Athenians employed sophisticated contingent contracts and litigated frequently (to the point that the law courts featured prominently in several famous comedies). Furthermore, the Athenians recognized that forgoing expertise was costly, and where the cost was particularly high, designed institutions that made use of expertise already existing in society, employed knowledgeable individuals who were unable to engage in significant rent seeking, or increased the private returns to collecting publicly beneficial information. Although the Athenian legal system differs in many ways from modern legal systems, it nonetheless functioned very effectively. Investigation of the Athenian system highlights how important it is for institutional designers to consider legal institutions as a bundle, whose pieces must complement one another.

On the Benefits and Costs of Legal Expertise: Adjudication in Ancient Athens

Legal expertise permits detailed laws to be written and enforced, but individuals with expertise may employ their special knowledge to skew decisions in privately beneficial directions. We illustrate this tradeoff in a simple model, which we use to guide our analysis of the legal system in ancient Athens. Rather than accepting the costs of expertise in return for the benefits, as do most modern societies, the Athenians designed a legal system that banned professional legal experts. And this was not because Athenian society was simple: The Athenians employed sophisticated contingent contracts and litigated frequently (to the point that the law courts featured prominently in several famous comedies). Furthermore, the Athenians recognized that forgoing expertise was costly, and where the cost was particularly high, designed institutions that made use of expertise already existing in society, employed knowledgeable individuals who were unable to engage in significant rent-seeking, or increased the private returns to collecting publicly beneficial information. Although the Athenian legal system differs in many ways from modern legal systems, it nonetheless functioned very effectively. Investigation of the Athenian system highlights how important it is for institutional designers to consider legal institutions as a bundle, whose pieces must complement one another.

The Impact of Royalty Contract Revision in a Multi-Stage Strategic R&D Alliance

This paper investigates the impact of royalty revision on incentives and profits in a two-stage (R&D stage and marketing stage) alliance with a marketer and an innovator. The marketer offers royalty contracts to the innovator. We find the potential for royalty revision leads to more severe distortions in the optimal initial royalty contracts offered by the marketer. We show if the innovator plays a significant role in the marketing stage, the marketer should offer a low royalty rate initially and then revise the royalty rate up later. Otherwise, she should do the opposite. We identify two major effects of royalty revision. First, royalty revision provides the marketer with a flexibility to dynamically adjust royalty rates across the two stages of the alliance to better align the innovator’s incentives. This incentive realigning effect improves the marketer’s profit. Second, royalty revision makes it harder for the marketer to obtain private information from the innovator because the innovator worries the marketer will take advantage of the information to revise the initial contract to a more favorable one to herself later. This information revealing effect hurts the marketer’s profit. We characterize in what kind of alliances marketers would benefit the most from royalty revision so that managers should clearly establish the expectation for royalty revision, and in what kind of alliances marketers would not benefit from royalty revision so that managers should commit not to revise the initial royalty contract. With royalty contracts that are contingent on the R&D outcome of the R&D stage, we find that contingent contract structure could be either substitutable (by fully capturing the incentive re-aligning effect) or complementary (by weakening the information revealing effect) to royalty revision depending on whether the innovator plays a significant role of the marketing stage. Managers may need to use contingent contract (if possible) either to replace or with royalty revision accordingly to improve profits.