Adverse selection analysis for profit and loss sharing contracts

Purpose: The purpose of this paper is to determine the optimal profit-and-loss sharing (PLS)-based contract when market frictions occur. Design/methodology/approach: This paper opts for an adverse selection analysis and Monte Carlo simulation to assess the less risky contract for the principal and the agent when musharakah, mudarabah and venture capital financings are used in imperfect markets. Furthermore, this framework enables us to capture the level of market frictions that the principal can bear and the level of audit that he/she may undertake to mitigate bankruptcy. Findings: The simulation results reveal thatMusharakahis the less risky contract for the principal compared toMudarabahand venture capital when the shock is low and high. Furthermore, our findings indicate that the increase of market frictions engender higher audit cost and profit-sharing ratios. The increase of the safety index in the case of high shock is most likely attributed to the increase of the audit parameter for all contracts to mitigate the selfish behavior of the agent. Accordingly, the principal tends to require a higher profit-sharing ratio to compensate for the severer information asymmetry. Research limitations/implications: This paper has two main limits. First, the results were not compared to real data because the latter are not available. Second, this paper is a general framework to determine the less risky contract for the principal and does not consider the firm and sectoral characteristics. However, it can be extended in various ways where stress can be put on conflicts of interest between the principal and the agent with the aim to determine the contract that aligns their interests. In addition, the examination of firm dynamics in the case of equity and debt financing can provide further arguments for economic agents regarding the value of the firm, the growth rate and the lifetime of the project when information is asymmetrically distributed. Practical implications: The findings shed some light on the necessity of the Islamic finance experts to re-think of the promotion ofMusharakahbecause it dominates the two other contracts when market frictions occur. Social implications: Although Maghrabi and Mirakhor (2015), Alanzi and Lone (2015) and Lone and Ahmad (2017) among others showed that profit and loss sharing can ensure economic growth, findings may motivate economic players to considerMusharakahfinancing with the aim to reach financial inclusion and social, which is in line withShari’ahrequirements and Islamic values. Originality/value: Although several papers highlighted the financial contracting theory fromShari’ahperspective, they ignored the financial issues that are associated to adverse selection. This paper provides theoretical evidence regarding the selection of the less risky financing mode in case of equity financing using Monte Carlo simulation.