Financial Contract Theory

Financial contract theory stemmed from agency theory and property rights theory in the 1980s, and the basic hypotheses of the theories are asymmetric information and incomplete contract. Then, economists make use of game theory to investigate financial contract issues, such as the control rights, cash flow rights, and the right to liquidate the agents' assets, which are assigned to the investors and managers. And the main objective of optimal financial contract design is to stimulate the investors to invest, to stimulate the managers to maximize firm value, and to stimulate the investors to supervise the management of the firm. So the theory gives important implications for the reformation of state-owned enterprises, the governance of private enterprises, and the development of capital market.At first, the thesis cast back the evolvement of financial contract research that stemmed from agency theory and property rights theory separately. Then, it explained the asymmetric information hypothesis and incomplete contract hypothesis, and presented the building blocks of financial contract theory. I divide the theory into financial constraint study and control right allocation study.Financial constraint study consists of the effort made to understand the impacts of the constraints induced by debt financing on managerial incentives and economic efficiency. The study is further divided into financial constraint models and renegotiation models. The former focuses on the tradeoff between mitigating incentive problems and the efficiency loss of punishing default. The latter focuses on the influences of contract structure on the renegotiation process and economic efficiency, and gives advices for contract structure choice.Control right allocation study consists of the effort made to understand theimpacts of control right allocation on managerial incentives and economic efficiency. And the study is further divided into control right allocation models and claim diversity models. The former focuses on the efficiency of different control right allocation mechanisms, and implies that the optimal mechanism assigns the control rights to the agent that can maximize firm value. The latter focuses on both financial constraints and control right allocation, and encompasses debt contract, equity contract, and managerial incentive contract in one optimal contract structure, which can minimize agency cost and maximize firm value.The thesis is organized as follows:Part one gave an overview of financial contract theory, which cast back the evolvement, analyzed the basic hypotheses, and laid out the building blocks of the theory.Part two analyzed the fruits of financial constraint study, which included the financial constraint models of Gale-Hellwig (1985), Bolton-Scharfstein (1990), and Zwiebel (1996), and the renegotiation models of Bolton-Scharfstein (1996), Hart-Moore (1998).Part three analyzed the fruits of control right allocation study, which included the control right allocation models of Aghion-Bolton (1992), and Fluck (1998, 2002), and the claim diversity models of Berglof-von Thadden (1994), Dewatripont-Tirole (1994), and Hart (2001).Part four is summary and implications, which summarized the main conclusions of financial contract theory, gave implications for China, and pointed out issues to be studied.The main innovations of the thesis are as follows:1. It gave a full sketch of the evolvement of financial contract theory, and analyzed its basic hypotheses.2. It laid out the building blocks of the theory, and analyzed some classic papersthat made great contribution to the theory.3. It summarized the main mechanisms of corporate governance in the view of debt contract, equity contract, and managerial incentive contract, and gave implications for China.