Can Real Options Reduce Moral hazards in Profit and Loss sharing contracts ?:
A Behavioural Approach Using Game Theory and Agent Based Simulation
Keywords:
Pls contracts, Agent Based Simulation, moral hasard, social value, Nash Equilibrium, Diminishing PLS ContractAbstract
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.