The agency theory deals with agency problems resulting from conflicts of interest that may emerge in contractual relationships when parties are differently informed or uncertain. The main objective of agency theory is to explain how contracting parties design contracts to minimize the costs associated with such problems. Agency theory also underscores the existence of market and institutional mechanisms that complete contracts to reduce these problems. Agency theory upon two key concepts: asymmetric information and creation of incentives. In order to understand agency problems and how agency theory explains the form of contracts, it is necessary to present the hypothesis of its models and the results provided by the theory. Description:
Agency theory is the branch of financial economics that looks at conflicts of interest between people with different interests in the same assets. This most importantly means the conflicts between: •
shareholders and managers of companies
shareholders and bond holders.
Agency theory explains, among other things, why:
companies so often make acquisitions that are bad for shareholders. •
convertible bonds are used and bonds are sometimes sold with warrants •
capital structure matters.
Agency theory is rarely, if ever, of direct relevance to portfolio investment decisions. It is used to by financial economists to model very important aspects of how capital markets function. However, investors gain a better understanding of markets by being aware of the insights of agency theory. One particularly important agency issue is the conflict between the interests of shareholders and debt holders. In particular, following a more riskier but higher return strategy benefits the shareholders to the detriment of the debt holders. It can easily be seen why debt holders lose out: a more risky strategy increases the risk of default on debt, but debt holders, being entitled to a fixed return, will not benefit from higher returns....
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