Can Real Options Reduce Moral hazards in Profit and Loss sharing contracts ?: A Behavioural Approach Using Game Theory and Agent Based Simulation

Adil El-fakir, Alireza Pakgohar

Research output: Contribution to journalArticlepeer-review


Agency problems between corporate managers and financiers/banks are common issues in corporate governance literature. We try reducing moral hazard problem of corporate managers’ profit misreporting as an agency problem in Profit and loss sharing contracts (PLS). We propose that the financier/bank sell a real option to the corporate manager giving her the right to gradually own the corporation in a process referred to as diminishing PLS. We use a repeated game theoretical approach by combining diminishing PLS with real options. To test our model, we create an agent-based simulation environment in Netlogo where we compare case of diminishing PLS with real options and the case without. We found evidence that under real options cooperation can be sustained by having Managers not misreporting profits. On the other hand, defection occurs under no real option. We also found that there exists a higher social value under real options than under the case without. To promote this case of high social value, it is necessary to provide the manager with a specified monetary incentive. This model is of practical use as it allows for the calculation of the real option premium and the monetary incentive to sustain true profit reporting.

Original languageEnglish
Pages (from-to)284 - 302
Number of pages18
JournalJournal of Islamic Business and Management
Publication statusPublished - 30 Dec 2020

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