Bilateral Financial Contracts

Economists have long been interested in how firms and individuals finance their activities, and there is a vast literature dealing with the relative supplies of different types of financial instruments. Two types of financial instrument are particularly important: debt contracts that promise investors a specified return in ‘normal’, non-default states and first claim to the issuer’s assets in default states; and equity contracts that give holders a claim on an issuer’s residual income (i.e., its profit) and ultimate control over its assets provided the issuer does not default. Traditionally, the finance literature has tended to focus on the supply of and demand for these financial instruments, but had relatively little to say on why those particular contract forms are used in the first place.1 This latter question — the ‘security design’ problem, as Harris and Raviv (1991, 2) call it — was neglected, and yet it has become increasingly apparent in recent years that the answers to some of the most basic issues in financial economics actually depend on it. If we do not understand why agents use the contract forms they do, then we can only have, at most, a limited understanding of firm capital structure and financing decisions, and, therefore, of everything that depends on them (e.g., the activities of financial intermediaries). A clear understanding of contract form is thus essential if we are to understand the more sophisticated issues to be considered later. Our first task must therefore be to establish what ‘optimal’ contracts look like, and how they relate to the contracts we observe in the ‘real’ world.