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Rewarding Trading Skills Without Inducing Gambling

Author

Listed:
  • Guillaume Plantin

    (Toulouse School of Economics)

  • Igor Makarov

    (London Business School)

Abstract

This paper develops a model in which traders may secretly take fair bets in complete markets in order to temporarily manipulate their reputation and attract more funds. It then solves for contracts that mitigate this friction. Such contracts must ensure that the present value of the trader's future payoffs is not too convex in her reputation. If the trader can commit to a long-term contract, she can achieve this by committing to leave a fraction of her future excess returns to investors if she turns out to be highly skilled. If the trader cannot commit to such behavior, then investors optimally commit to overcompensate the trader if she turns out to be unskilled. In both cases, the net excess returns earned by competitive, uninformed investors exhibit persistence.

Suggested Citation

  • Guillaume Plantin & Igor Makarov, 2010. "Rewarding Trading Skills Without Inducing Gambling," 2010 Meeting Papers 899, Society for Economic Dynamics.
    • Handle: RePEc:red:sed010:899
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    References listed on IDEAS

    as
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    4. Kosowski, Robert & Naik, Narayan Y. & Teo, Melvyn, 2007. "Do hedge funds deliver alpha? A Bayesian and bootstrap analysis," Journal of Financial Economics, Elsevier, vol. 84(1), pages 229-264, April.
    5. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
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