Dynamic contracting with imperfect observability

Abstract:

This paper is concerned with a continuous time, dynamic contracting problem in which the principal observes performance at discrete intervals only. In spite of this, incentive compatibility can be enforced pathwise, but at additional costs to the principal.  The discrete nature of the information of the principal gives rise to a mixed problem with continuous and discrete impulse control that is characterised by a quasi-variational inequality. We characterise the contract and compute the probability of over-payment, as well as the expected cost of these over-payments. Finally we implement the contract in securities, which display real-life characteristics like special dividends.