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Managerial incentives and financial contagion

  • Sujit Chakravorti
  • Anna Ilyina
  • Subir Lall

This paper proposes a framework to examine the comovements of asset prices with seemingly unrelated fundamentals, as an outcome of the optimal portfolio strategies of large institutional fund managers. In emerging markets, the dominant presence of dedicated fund managers whose compensation is linked to the outperformance of their portfolio relative to a benchmark index, and of global fund managers whose compensation is linked to the absolute returns of their portfolios, leads to portfolio decisions that result in systematic interactions between asset prices even in the absence of asymmetric information. The model endogenously determines the optimal amount of cash holdings or leverage, the incidence of relative value versus macro hedge fund strategies, and how prices can systematically deviate from the long-term fundamental value for long periods of time, with limits to the arbitrage of this differential. Managerial compensation contracts, while optimal at a firm level, may lead to inefficiencies at the macroeconomic level. We identify conditions when a negative shock to one emerging market affects another market negatively.

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Paper provided by Federal Reserve Bank of Chicago in its series Working Paper Series with number WP-03-21.

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Date of creation: 2003
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Handle: RePEc:fip:fedhwp:wp-03-21
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  1. Reinhart, Carmen & Kaminsky, Graciela, 1998. "On crises, contagion, and confusion," MPRA Paper 13709, University Library of Munich, Germany.
  2. Calvo, Sara & Reinhart, Carmen, 1996. "Capital flows to Latin America : Is there evidence of contagion effects?," Policy Research Working Paper Series 1619, The World Bank.
  3. Laura E. Kodres & Matthew Pritsker, 2002. "A Rational Expectations Model of Financial Contagion," Journal of Finance, American Finance Association, vol. 57(2), pages 769-799, 04.
  4. Kaminsky, Graciela L. & Schmukler, Sergio L., 1999. "What triggers market jitters? A chronicle of the Asian crisis," Policy Research Working Paper Series 2094, The World Bank.
  5. Banerjee, Abhijit V, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, MIT Press, vol. 107(3), pages 797-817, August.
  6. Guillermo A. Calvo & Enrique G. Mendoza, 1999. "Regional Contagion and the Globalization of Securities Markets," NBER Working Papers 7153, National Bureau of Economic Research, Inc.
  7. Albert S. Kyle, 2001. "Contagion as a Wealth Effect," Journal of Finance, American Finance Association, vol. 56(4), pages 1401-1440, 08.
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