Excerpt from A Commodity Linked Bond as an Optimal Debt Instrument in the Presence of Moral Hazard

In this paper we communicate two results. First, we construct an example in which a firm strictly prefers to issue a bond linked to the price of a commodity as opposed to a fixed rate bond. The firm with a fixed rate bond chooses a suboptimal investment policy because the outstanding nominal obligation distorts the incentives of the equity owners. The commodity linked bond resolves this moral hazard problem.

Second, we show that in the presence of moral hazard problems the traditional application of contingent claims valuation techniques leads to an incorrect valuation of the the real assets and consequently to an incorrect valuation of the financial liabilities written against those assets. We show how the technique can be adapted to yield correct valuations.

Visiting Professor of Finance and Assistant Professor of Finance, respectively, Sloan School of Management, m.i.t.

This research is supported in part by the Program on Investments, Finance, and Contracts of the Center for Energy Policy Research, Energy Laboratory, m.i.t.

The use of commodity linked debt has been advocated by Lessard primarily as an instrument to improve risk sharing between less developed countries that are significantly dependent upon commodity exports and outside investors. Lessard also noted that the improved risk sharing would have consequences for capital budgeting. However, his argument did not focus upon the very direct nature in which a commodity linked bond could improve the equity owner's incentives to choose the optimal investment and Operating strategy. Lessard's suggestion has become quite popular, and there now exist many pr0posals for indexing of less developed country debt to the prices of various commodities or directly to export earnings. However, almost all of the literature continues to focus upon the problem of improved risk sharing. There is almost no attention given to the improved use of the real assets that can result from the proper design of commodity linked debt. In this paper we focus exclusively on the changes in use of the real assets. Our analysis demonstrates, therefore, why a commodity linked bond may be an optimal financing instrument for a project in a developed country as well as a project in a less developed country. It should be noted that the great majority of commodity linked bonds have been issued in developed countries and that many of the issues have been made by industrial corporations involved in mining or processing the relevant commodities as our analysis would predict and in contradiction to the predictions of most other explanations for the existence of these securities. Our analysis calls attention, moreover, to the fact that the optimal commodity linked contract must be tailored to the particular set of real assets being financed.

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