Abstract

We study a principal-agent model of moral hazard in which the principal has an abandonment option. The option to abandon a project midstream limits a firm's downside risk. From a consumption (production) perspective, the option is clearly beneficial. However, from an incentive perspective, the option can be costly. Removing the lower tail of the project's underlying cash flow distribution also eliminates the information it contains about an agent's (unobservable) productive input. In addition, there is also the issue that the option holder cannot always (ex ante) commit to the precise circumstances under which the option will be exercised. These concerns introduce an interaction in the valuation of the abandonment option and information system. In particular, the manner in which information is coarsened and the direction of the flow of information are critical design parameters that affect option value.

Citation

Arya, A., and Jonathan Glover. "Abandonment Options and Information System Design." Review of Accounting Studies 8, no. 1 (March 2003): 29-45.

Each author name for a Columbia Business School faculty member is linked to a faculty research page, which lists additional publications by that faculty member.

Each topic is linked to an index of publications on that topic.