Contractual incompleteness, limited liability and bubbles

Dow, J and Han, J (2015) Contractual incompleteness, limited liability and bubbles. Journal of Financial Economics, 116 (2). pp. 383-409. ISSN 0304-405X


When should we expect bubbles? Can levered intermediaries bid up risky asset prices through asset substitution? We study an economy with financial intermediaries that issue debt and equity to buy risky assets. Asset substitution alone cannot cause bubbles because it is priced into the intermediaries׳ securities. But incomplete contracts and managerial agency problems can make intermediaries take excessive risk to exploit limited liability, bidding up risky asset prices. This destroys welfare through misallocation of resources. We argue that incentives for private monitoring cannot solve this problem. Finally, even without agency problems, debt subsidies will create similar effects.

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Item Type: Article
Subject Areas: Finance
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© 2015 Elsevier

Subjects: F > Financial risk
A > Assets
Date Deposited: 18 May 2016 11:18
Last Modified: 23 Dec 2019 14:33

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