Calibrated Incentive Contracts

Abstract

This paper studies a financial agency problem which includes limited liability, moral hazard and adverse selection. The paper develops a robust approach to dynamic contracting based on calibrating the payoffs that would have been delivered by simple benchmark contracts that are attractive but infeasible, due to limited liability constraints. The resulting contracts are detail-free and perform well independently of the underlying process for returns. The paper discusses how these calibrated contracts relate and differ from contracts used in practice.