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Adverse Risk Incentives and the Design of Performance-Based Contracts

Author

Listed:
  • Mark Grinblatt

    (Anderson Graduate School of Management, University of California, Los Angeles, California 90024)

  • Sheridan Titman

    (Anderson Graduate School of Management, University of California, Los Angeles, California 90024)

Abstract

This paper uses option pricing theory to value and analyze many performance-based fee contracts that are currently in use. A potential problem with some of these contracts is that they may induce portfolio managers to adversely alter the risk of the portfolios they manage. The paper is prescriptive in that it presents conditions for contract parameters that provide proper risk incentives for classes of investment strategies. For buy-and-hold and rebalancing strategies adverse risk incentives are avoided when the penalties for poor performance outweigh the rewards for good performance.

Suggested Citation

  • Mark Grinblatt & Sheridan Titman, 1989. "Adverse Risk Incentives and the Design of Performance-Based Contracts," Management Science, INFORMS, vol. 35(7), pages 807-822, July.
    • Handle: RePEc:inm:ormnsc:v:35:y:1989:i:7:p:807-822
    DOI: 10.1287/mnsc.35.7.807
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