A debt contract is incentive compatible
A)if the borrower has the incentive to behave in the way that the lender expects and desires,since doing otherwise jeopardizes the borrower's net worth in the business.
B)if the borrower's net worth is sufficiently low so that the lender's risk of moral hazard is significantly reduced.
C)if the debt contract is treated like an equity.
D)if the lender has the incentive to behave in the way that the borrower expects and desires.

Question

Quizplus · Accepted Answer

Incentive compatibility in a debt contract refers to the alignment of incentives for both the borrower and the lender. In this context, it means that the borrower has a strong incentive to behave in a way that is in line with the lender's expectations and desires since failure to do so would jeopardize their net worth in the business. This ensures that the borrower is motivated to meet the terms of the contract and repay the loan, reducing the risk of moral hazard for the lender.

A Debt Contract Is Incentive Compatible