Robust Contracts in Continuous Time

Abstract

We study a continuous-time contracting problem under hidden action,where the principal has ambiguous beliefs about the project cash flows.The principal designs a robust contract that maximizes his utility underthe worst-case scenario subject to the agent's incentive andparticipation constraints. Robustness generates endogenous beliefheterogeneity and induces a tradeoff between incentives and ambiguitysharing so that the incentive constraint does not always bind. Weimplement the optimal contract by cash reserves, debt, and equity. Inaddition to receiving ordinary dividends when cash reserves reach athreshold, outside equity holders also receive special dividends orinject cash in the cash reserves to hedge against model uncertainty andsmooth dividends. The equity premium and the credit yield spreadgenerated by ambiguity aversion are state dependent and high fordistressed firms with low cash reserves.