TITLE: Optimal Long-term Contracting with Learning

SPEAKER:  Dr. Bin Wei
Economist, Capital Markets
Board of Governors of the Federal reserve System,
Washington D.C.

ABSTRACT:

We introduce profitability uncertainty into an infinite-horizon variation of the classic Holmstrom and Milgrom (1987) model, and studies optimal dynamic contracting with endogenous learning.  The agent's potential belief manipulation leads to the hidden information problem, which makes incentive provisions intertemporally linked in the optimal contract. We reduce the contracting problem into a dynamic programming problem with one state variable, and characterize the optimal contract with an ordinary differential equation. In the benchmark case of Holmstrom and Milgrom (1987) without learning, the optimal effort is constant, and the optimal contract is linear. In contrast, in our model with endogenous learning, the optimal effort policy becomes history dependent, and decreases over time on average. Moreover, we show that the optimal contract exhibits an option-like feature in that the incentives rise after good performance shocks.

Short bio:
Dr. Bin Wei is currently an economist at the Capital Markets section of Research & Statistics Division at the Board of Governors of the Federal Reserve System. Before joining the Board in September 2011, he had been an assistant professor of finance at Baruch College, the City University of New York for four years between 2007 and  2011. He is interested in a broad range of topics, such as, optimal contracting, delegated portfolio management, liquidity and credit risk modeling, market microstructure. He has published two papers in one of the top finance journals, Review of Financial Studies. Dr. Bin Wei got his Ph.D. in finance from Duke University in 2007 and M.A. in statistics from University of Pennsylvania in 2002.