Bond Covenants and Delegated Monitoring.

Abstract

This paper examines alternative contracting arrangements available to a firm seeking to finance an investment project. The authors consider the choice between loan contracts with covenants bas ed on noisy indicators of the firm's financial health and loan contra cts enforced by a monitoring specialist. In one interpretation, the s pecialist is a financial intermediary. The firm's choice is shown to depend upon the firm's credit rating, the accuracy of financial indic ators of the firm's condition, the loss from premature liquidation of the firm's project, and the cost of monitoring. Copyright 1988 by American Finance Association.