A continuous-time dynamic contracting problem with limited liability and finite horizon

Abstract

We perform a detailed study of a principal--agent problem in a continuous time version of the celebrated Holmstr\"om--Milgrom model (Econometrica 55 (2), 1987) where we add limited liability for the Agent. We develop a probabilistic methodology to prove that the Principal's value function is the unique bounded classical solution to a fully nonlinear and fully degenerate partial differential equation (PDE) with Cauchy-Dirichlet boundary conditions on $[0,T]\times[0,\infty)$. Indeed, we also prove infinite continuous differentiability of the solution in the interior of the domain. The strength of our regularity result is such that we can ensure existence of optimal controls in strong form---a rare occurrence in dynamic contracting---and we obtain fine properties of the optimal control map, including a characterisation via a further nonlinear degenerate PDE.