Can Real Options Reduce Moral hazards in Profit and Loss sharing contracts ?:

A Behavioural Approach Using Game Theory and Agent Based Simulation

Authors

  • Adil EL Fakir, Senior Lecturer Sheffield Hallam University
  • Mohamed Tkiouat, Prof Professor of Game Theory
  • Richard Fairchild, Associate Professor University of Bath
  • Alireza Pakgohar, Senior lecturer Sheffield Hallam University

Keywords:

Pls contracts, Agent Based Simulation, moral hasard, social value, Nash Equilibrium, Diminishing PLS Contract

Abstract

Agency problems between corporate managers and financiers/banks are common

issues in corporate governance literature. We try reducing moral

hazards problem of corporate managers’ profit misreporting as an agency problem

in Profit and loss sharing contracts (PLS). We propose

that the financier/bank sell a real option to the corporate manager giving her the

right to gradually own the corporation in a process referred to as diminishing PLS. We use a repeated game theoretical approach by combining diminishing PLS with real options. To test our model, we create an agent-based simulation environment in Netlogo

where we compare case of diminishing PLS with real options and the

case without. We found evidence that under real options cooperation can be sustained

by having Managers not misreporting profits. On the other hand, defection

occurs under no real option. We also found that there exists a higher social value

under real options than under the case without. To promote this case of high social

value, it is necessary to provide the manager with a specified monetary incentive.

This model is of practical use as it allows for the calculation of the real option

premium and the monetary incentive to sustain true profit reporting.

 

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Published

2020-12-30