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Risk Taking and Optimal Contracts for Money Managers

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  • Palomino, F.A.

    (Tilburg University, Center For Economic Research)

  • Prat, A.

    (Tilburg University, Center For Economic Research)

Abstract

Recent empirical work suggests a strong connection between the incentives money managers are offered and their risk-taking behavior. We develop a general model of delegated portfolio management, with the feature that the agent can control the riskiness of the portfolio. This represents a departure from the existing literature on agency theory in that moral hazard is not only effort exertion but also risk taking behavior. The moral hazard problem with risk taking involves an incentive-compatibility constraint on risk, which we characterize. We distinguish between one period and several periods. In the former case, under mild conditions, there exists a first-best contract which takes the form of a bonus contract. In the latter, we show that there exists no first-best contract and we use a numerical approximation to study the properties of the second-best contract.Recent empirical work suggests a strong connection between the incentives money managers are offered and their risk-taking behavior. We develop a general model of delegated portfolio management, with the feature that the agent can control the riskiness of the portfolio. This represents a departure from the existing literature on agency theory in that moral hazard is not only effort exertion but also risk taking behavior. The moral hazard problem with risk taking involves an incentive-compatibility constraint on risk, which we characterize. We distinguish between one period and several periods. In the former case, under mild conditions, there exists a first-best contract which takes the form of a bonus contract. In the latter, we show that there exists no first-best contract and we use a numerical approximation to study the properties of the second-best contract.
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Suggested Citation

  • Palomino, F.A. & Prat, A., 1998. "Risk Taking and Optimal Contracts for Money Managers," Discussion Paper 1998-108, Tilburg University, Center for Economic Research.
    • Handle: RePEc:tiu:tiucen:3da5cec4-4ab5-495a-8786-3c2925022e41
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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