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The author would like to thank Peter Clark, Charles Collyns, Steven Dunaway, Victor Ng, and Robert Rennhack for helpful comments and suggestions. The views expressed in the paper and any remaining errors are the author’s.
The result holds when both parties are risk averse. Grossman and Hart (1983), Holmstrom (1979) and Shavell (1979) analyze the trade-off between incentive provision and efficient risk sharing in contract theory. Stiglitz and Weiss (1981) and (1983) apply principal-agent models in domestic credit markets. They explain credit rationing in markets with incomplete information, and they investigate the incentive effects of contingent contracts that take into account the possibility of the termination of the relationship between the two contracting parties.
This is known in the corporate finance literature as the “asset substitution problem” which arises because lenders, in general, know less about the riskiness of the projects than borrowers. When the lender determines a certain fixed interest rate, the spread between this rate and the risk free rate (the risk premium) is set to reflect the default probability based on the information available to the lender at the time when the loan is initiated. A problem arises because the default probability, after the loan is granted, is affected by the actions of the borrower. If the contract permits the borrower some flexibility in terms of its investment decision, then the borrower may have the incentive to undertake a more risky project (but with a higher expected return) than the one based on the original understanding of the lender. By doing so, the borrower essentially obtains the funds for a riskier project at a lower risk premium.
Condition (8) implies Pareto optimality from a risk sharing point of view. From Borch (1962), we know that the contract is Pareto optimal from a risk sharing point of view if the ratio of the two marginal rates of substitution is constant.
Barnea, Haugen and Senbet (1985) present a detailed analysis of the importance of agency problems in corporate finance in domestic markets.
Atkeson (1991), Gertler and Rogoff (1990) and Kletzer (1989) provide a theoretical analysis of the importance of asymmetric information in various aspects of international lending, including the moral hazard problem, the risk of repudiation, and the possibility of contract renegotiation. Grossman and Van Huyck (1988) consider sovereign debt default as a contingent claim resulting from adverse external developments.
See Chapter V in Private Market Financing for Developing Countries, IMF, (Washington, December 1993), Chapters IV and V in Private Market Financing for Developing Countries, IMF, (Washington, December 1992), and the report on Developing Country Access to Private Capital Flows, EB/CW/DC/93/2 (March 15, 1993), prepared as background for the spring 1993 meeting of the Development Committee.
See Chapter III in Private Market Financing for Developing Countries, IMF, (Washington, December 1993), and Chapter VIII in International Capital Markets--Developments and Prospects, and Key Policy Issues. Part II-Background Material on Systemic Issues in International Finance, (Washington: IMF, 1993), for details on recent efforts in creditor countries to improve the flow of financial information about developing country securities.
See Chapter III in Private Market Financing for Developing Countries, IMF, (Washington, December 1993).
See Chapter VI in Private Market Financing for Developing Countries, IMF, (Washington, December 1993).