Dynamic Incentive Contracts with Controllable Risk

We develop a continuous-time dynamic contracting model where a risk-neutral principal hires a risk-averse agent to manage a project. The project risk is controlled by the principal or agent, and there is a trade-off between risk premium and a value-destroying effect of risk. No-saving selection can be exogenous or endogenous. We show that contract efficiency reaches the maximum if agents control project risk, and the higher the agent's promised value, the more significant the advantage over the case where principals control the risk. The contract efficiency under project risk controlled by the agent would exceed that controlled by the principal by over 4.3%. There is a contract efficiency's difference resulting from exogenous and endogenous no-savings selections, and it would be positive or negative due to the principal's different decision rules, though the difference is small