Moral Hazard, Aggregate Risk and Linear Financial Contracts

We study competitive equilibria with moral hazard in economies with aggregate risk and where trading occurs with an incomplete set of ...nancial assets. The main conclusion of the paper is that, contrary to the individual risk economies, moral hazard is compatible with trading in competitive linear ...nancial contracts, and gives rise to no manipulation problem. We establish existence of nonmanipulable equilibria provided that there are no relative price e¤ects (e.g. a one-commodity economy), and that ...nancial markets display nonlinearly homogeneous payo¤s (e.g., nominal), and are su¢ciently incomplete. Finally, we justify the linear contract as the optimal pricing schedule in a speci...c trading game with an auctioneer. Journal of Economic Literature Classi...cation Numbers: D50, D82.