Microeconomics of Banking



Financial Contracting

Karel Janda

Syllabus for Fall 2015

Email: Karel-Janda@seznam.cz

Office Hours:

Monday 9:30-11:30 room 408, Opletalova 26;

Tuesday 12:40-14:40 room 182NB, W. Churchilla Square 4.

Explanations:

W.Churchilla Square 4 is the main building of University of Economics, Prague.

Opletalova 26 is the building of Institute of Economic Studies of Charles University.

Brief Overview of the Course

The theory of financial contracting analyzes situations in which capital markets are imperfect and financial decisions effect the cash flow of the firm. This will be the case when information is asymmetric or contracts are incomplete. This is a technique oriented class. The financial contracting techniques covered in the class may be used to explain the features of financial arrangements, such as debt contracts and equity-shares, which are taken for granted in more traditional finance theory. The class also deals with the problems of optimal risk sharing and insurance. The course requires solid knowledge of microeconomic theory on intermediate level with calculus. The familiarity with simple calculus techniques of optimization as used in microeconomic models is essential.

Goals

Students will learn rigorous foundations of financial contracting. Students will understand the incentive properties of optimal financial contracts and their implications for the optimal financial structure. Students will present short examples of contracts found in "real life".

These short presentations will be dealing with the relevance of covered topics for everyday practical life. Students will find in a newspaper or on the internet some example of contracting situation and will talk about this situation in class. The presentation will be brief, up to 5 minutes is enough. Good newspaper story will usually not mention moral hazard, adverse selection, signaling or any contracting terms we are using in the class. But students will notice that the situation described nicely fits into some of the stylized models, we are covering in the class. So during your brief presentation you will introduce particular newspaper or internet story and you will show how it relates to the formal theory we cover in the class. These short presentations are voluntary. You do not have to present anything and you still have a very good chance of passing the class if your exam results are decent. But a good presentation may compensate for possible deficiencies in your exam, so I strongly recommend you to have your eyes open, to look for instances of real life contracts and to relate them to the contract theory we cover in the class.

Intended Audience

Master (magistr in Czech terminology) level students interested in banking or optimal contracting.

The course is also useful for the Ph.D. students in finance or economics.

The Topics Covered

Lecture 1: Overview of contract theory, examples of moral hazard, adverse selection, signalling. Concavity and optimization. (Macho-Stadler, Perez-Castrillo (MSPC) ch. 1, Math Appendix)

Lecture 2: Kuhn-Tucker conditions. (MSPC Math Appendix)

Lecture 3: Base Model - symmetric information, optimal payment mechanism in Base Model. (MSPC ch. 2)

Lecture 4: Base Model continued - different attitudes to risk, optimal level of effort. (MSPC ch. 2)

Lecture 5: Moral hazard - two effort levels. (MSPC ch.3.1-3.3)

Lecture 6: Two effort levels continued. (MSPC ch. 3.3)

Lecture 7: First order approach, financial contracting examples. (MSPC ch. 3.4)

Lecture 8: Financial contracting examples. Introduction to signalling .

Lecture 9: Signalling - Bayeasian Nash Equilibrium.

Lecture 10: Signalling - refinements of Bayesian Nash Equilibrium. Real life presentations.

Lecture 11: Financial contracting applications.

Lecture 12: Real life presentations.

Lecture 13: Conclusion of the class.

Grading

Students are evaluated according to written exam and activity in the class. Grading is based on letter grades (A=1,B=2,C=3,Fail=4) system. Cheating or other academic dishonesty during exam implies failing the class without any possibility to make up the exam. Any communication among the students during the exam is considered as cheating. Therefore during the exam communicate only with the exam supervisor. You may take watch and simple calculator for exams. Do not take any mobile phones or any other electronic devices for exams.

Because I expect that many of you, especially the international students, will not be able to come to class before Christmas on Tuesday December 15, we do not schedule any teaching or exam for that day.

The exam will be on Tuesday December 8, 2015 in the usual place and time of our class.

Sample exam is available at

Libraries, teaching texts availability:

I will try to provide you with relevant handouts. There are libraries with books relevant to our class both at University of Economies and Institute of Economic Studies. I asked the librarians at University of Economies and Institute of Economic Studies to put one copy of the main textbook for our class on reserve. I also arranged for a few copies of Microeconomics of Banking and An Introduction to the Economics of Information: Incentives and Contracts to be available for take-home loans at Institute of Economic Studies library. In addition, the best economic library in Prague is at CERGE-EI on Politickych veznu 7 street. The CERGE-EI library has all the books relevant for our class, some of them available for take-home loans.

You may also buy the textbooks over the Internet or ordering them through some local bookshop like



The textbooks for this class are also available for free download on Internet. I am not going to distribute the addresses of the Internet places for free downloads.

References:

I. Macho-Stadler and J. D. Perez-Castrillo: An Introduction to the Economics of Information: Incentives and Contracts Oxford, Oxford University Press, 2001 – main textbook.

R. Gibbons: Game Theory for Applied Economists, Princeton University Press, 1992 - good treatment of signalling and other game theoretic issues.

A few additional references for those who want more books to study:

Jean Tirole: The Theory of Corporate Finance, Princeton University Press, 2006

Patrick Bolton, Mathias Dewatripont: Contract Theory, 2005

Martin J. Osborne: An Introduction to Game Theory, 2003

Mathias Dewatripont, Jean Tirole: The Prudential Regulation of Banks, 1994

X. Freixas and J. Rochet: Microeconomics of Banking, Cambridge, MIT Press, 1997 (1st edition) or 2008 (2nd edition) - supplementary textbook with application to banking.

O. Hart: Firms, Contracts, and Financial Structure, Clarendon Press, 1995 – supplementary textbook.

J. Laffont and D. Martimort: The Theory of Incentives: The Principal-Agent Model. Princeton University Press, 2002 - supplementary textbook. State of the art textbook treatment of contract theory.

B. Salanie: The Economics of Contracts. A Primer, Cambridge, MIT Press, 2005. – supplementary textbook, more advanced than Macho-Stadler and Perez-Castrillo.

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