Dynamic Contracting under Imperfect Observability

Abstract

This paper is concerned with a continuous time, dynamic contracting problem in which the principal observes performance at discrete intervals only. In spite of this, incentive compatibility can be enforced pathwise, but at additional costs to both the principal and the agent. The discrete nature of the information of the principal gives rise to a mixed problem with continuous and discrete impulse control that is represented as a quasi-variational inequality. We characterise the contract and compute the expected cost of these overpayments and underpayments. Finally we implement the contract in securities, which display real-life characteristics like special dividends.