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Strategic Asset Allocation in Money Management

  • Suleyman Basak

    ()

    (London Business School and CEPR)

  • Dmitry Makarov

    ()

    (New Economic School)

This article analyzes the dynamic portfolio choice implications of strategic interaction among money managers. The strategic interaction emerges as the managers compete for money flows displaying empirically documented convexities. A manager gets money flows increasing with performance, and hence displays relative performance concerns, if her relative return is above a threshold; otherwise she receives no (or constant) flows and has no relative concerns. We provide a tractable formulation of such strategic interaction between two risk averse managers in a continuous-time setting, and solve for their equilibrium policies in closed-form. When the managers’ risk aversions are considerably different, we do not obtain a Nash equilibrium as the managers cannot agree on who loses (getting no flows) in some states. We obtain equilibria, but multiple, when the managers are similar since they now care only about the total number of losing states. We recover a unique equilibrium, however, when a sufficiently high threshold makes the competition for money flows less intense. The managers’ unique equilibrium policies are driven by chasing and contrarian behaviors when either manager substantially outperforms the opponent, and by gambling behavior when their performances are close to the threshold. Depending on the stock correlation, the direction of gambling for a given manager may differ across stocks, however the two managers always gamble strategically in the opposite direction from each other in each individual stock.

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Paper provided by Center for Economic and Financial Research (CEFIR) in its series Working Papers with number w0158.

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Length: 42 pages
Date of creation: Aug 2009
Date of revision:
Handle: RePEc:cfr:cefirw:w0158
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  1. Jér�me B. Detemple & René Garcia & Marcel Rindisbacher, 2003. "A Monte Carlo Method for Optimal Portfolios," Journal of Finance, American Finance Association, vol. 58(1), pages 401-446, 02.
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  4. Alexander Kempf & Stefan Ruenzi, 2008. "Tournaments in Mutual-Fund Families," Review of Financial Studies, Society for Financial Studies, vol. 21(2), pages 1013-1036, April.
  5. Lóránth, Gyöngyi & Sciubba, Emanuela, 2002. "Relative Performance, Risk and Entry in the Mutual Fund Industry," CEPR Discussion Papers 3504, C.E.P.R. Discussion Papers.
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  7. Jennifer Carpenter, 1999. "Does Option Compensation Increase Managerial Risk Appetite?," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-076, New York University, Leonard N. Stern School of Business-.
  8. Jules H. van Binsbergen & Michael W. Brandt & Ralph S.J. Koijen, 2006. "Optimal Decentralized Investment Management," NBER Working Papers 12144, National Bureau of Economic Research, Inc.
  9. Palomino, Frederic, 2005. "Relative performance objectives in financial markets," Journal of Financial Intermediation, Elsevier, vol. 14(3), pages 351-375, July.
  10. Anand M. Goel & Anjan V. Thakor, 2005. "Green with Envy: Implications for Corporate Investment Distortions," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2255-2288, November.
  11. Jaksa Cvitanic & Levon Goukasian & Fernando Zapatero, 2000. "Monte Carlo Valuation of Optimal Portfolios in Complete Markets," Econometric Society World Congress 2000 Contributed Papers 1246, Econometric Society.
  12. Basak, Suleyman & Pavlova, Anna & Shapiro, Alex, 2006. "Optimal Asset Allocation and Risk Shifting in Money Management," CEPR Discussion Papers 5524, C.E.P.R. Discussion Papers.
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