- Principal amount is the total amount borrowed or lent exclusive of interest or premium.
- The party in a principal–agent relationship who hires an agent to act on his or her behalf. A principal–agent problem (or an agency problem) arises due to asymmetric information of either the hidden actions or hidden information type and the fact that the two parties have different objectives. For example, in a owner–manager relationship the principal owner may not be able to observe the effort choice of the manager; in a bank–borrower relationship the bank may not be able to distinguish the type of the borrower; in a relationship between insurance companies and insured individuals, the insurance company cannot observe the effort level of the individual to avoid the loss against which he has insured. the unobserved actions or information of the agent affect the payoffs of the two parties differently giving rise to a conflict of interests. In order to overcome this problem, the principal must design a compensation scheme or contract to provide the agent with incentives to act in the principal’s interests. the optimal compensation scheme maximizes the principal’s expected utility subject to the agent’s individual rationality constraint to ensure the agent is willing to accept the contract and the agent’s incentive compatibility constraint to ensure the agent undertakes the action that maximizes his expected utility given the contract.