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Risk Taking and Optimal Contracts for Money Managers

  • Palomino, Frederic
  • Prat, Andrea

We study delegated portfolio management when the agent controls the riskiness of the portfolio. Under general conditions, we show that the optimal contract is simply a bonus contract: the agent is paid a fixed sum if the portfolio return is above a threshold. We derive a criterion to decide whether the optimal contract induces excessive or insufficient risk. If a deviation from efficient risk taking causes a large (small) reduction in the expected return of the portfolio, the optimal contract induces excessive (insufficient) risk. In other words, the cheaper it is to play with risk, the less risk the agent takes. Copyright 2003 by the RAND Corporation.

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Article provided by The RAND Corporation in its journal RAND Journal of Economics.

Volume (Year): 34 (2003)
Issue (Month): 1 (Spring)
Pages: 113-37

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Handle: RePEc:rje:randje:v:34:y:2003:i:1:p:113-37
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  1. William N. Goetzmann & Jonathan Ingersoll, Jr. & Stephen A. Ross, 1998. "High Water Marks," NBER Working Papers 6413, National Bureau of Economic Research, Inc.
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  3. Peter Diamond, 1998. "Managerial Incentives: On the Near Linearity of Optimal Compensation," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 931-957, October.
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  10. Christian Gollier & Pierre-François Koehl & Jean-Charles Rochet, 1996. "Risk-Taking Behavior with Limited Liability and Risk Aversion," Center for Financial Institutions Working Papers 96-13, Wharton School Center for Financial Institutions, University of Pennsylvania.
  11. 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.
  12. Matutes, Carmen & Vives, Xavier, 1996. "Competition for Deposits, Fragility, and Insurance," Journal of Financial Intermediation, Elsevier, vol. 5(2), pages 184-216, April.
  13. Heinkel, Robert & Stoughton, Neal M, 1994. "The Dynamics of Portfolio Management Contracts," Review of Financial Studies, Society for Financial Studies, vol. 7(2), pages 351-87.
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  16. Jewitt, Ian, 1988. "Justifying the First-Order Approach to Principal-Agent Problems," Econometrica, Econometric Society, vol. 56(5), pages 1177-90, September.
  17. Bengt Holmstrom & Paul R. Milgrom, 1985. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Cowles Foundation Discussion Papers 742, Cowles Foundation for Research in Economics, Yale University.
  18. Susan I. Cohen & Laura T. Starks, 1988. "Estimation Risk and Incentive Contracts for Portfolio Managers," Management Science, INFORMS, vol. 34(9), pages 1067-1079, September.
  19. Innes, Robert D., 1990. "Limited liability and incentive contracting with ex-ante action choices," Journal of Economic Theory, Elsevier, vol. 52(1), pages 45-67, October.
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