Equilibrium Equity Premium, and Interest Rate of a Large-Firm Economy in the Presence of Moral Hazard

We present an equilibrium model of a moral-hazard economy with a very large firm and financial markets, where a stock and bonds are traded. We show that optimal contracts necessitate the principal to forbid the agent to trade the stock, and that moral hazard problems can result in low interest rates and sometimes in high equity premium. We also obtain a number of striking results: the second best cost of capital for a risky production asset can be lower than that of the first best; and the market price of risk depends on agent’s productivity as well as the risk aversion of both the principal and agent, and the volatility of the production asset. Moreover, comparative statics for both the firstand second-best cases suggest that the larger the social wealth, the lower the interest rate and the higher the market price of risk; and that low interest rates can also be resulted from low agent’s effort efficiency, low-profit production opportunities, and high production risk. JEL classification: D51, D53, D86, G11, G21, G31.