Modern Financial Systems: Theory and Applications

CHAPTER 7

Terms of Deals

This chapter explains how the terms of a deal can fine tune the capabilities utilized in its governance. In particular, the informational conditions under which a deal is originated, and the likely evolution of that information, have important implications for selecting deal terms. When deals are arranged under risk, they can be formulated as complete contracts. In addition, when they are arranged under conditions of symmetric information, it is relatively easy to select appropriate terms. However, if the deals are arranged under conditions of information asymmetry, they usually present potential complications of moral hazard and adverse selection. Each can be governed effectively, but at the expense of incurring additional costs. Finally, when deals are arranged under uncertainty the contracts are necessarily incomplete, and as a result their governance requires different methods and terms. Although a few exceptions are noted, in almost every instance the terms examined in this chapter are likely to be implemented by an intermediary or internally rather than a market agent, illustrating how the details of nonarm’s-length governance differ from the governance provided by market agents.

This chapter also examines how deal terms are used to fine tune agreements between financier and client. The discussion emphasizes the financier’s perspective, since he or she usually proposes a standard set of terms to be negotiated. If the applicant finds the terms generally ...