Risk Taking and Optimal Contracts for Money Managers

Abstract

Recent empirical work suggests a strong connection between the incentives money managers are o®ered 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 e®ort 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, we derive conditions for the existence of a¯rst-best contract. In the latter, we show that there exists no¯rst-best contract and we use a numerical approximation to study the properties of the second-best contract.

Collateralized borrowing and risk taking at low interest rates

“…While risk taking incentives of other types of intermediaries have been analyzed in the literature (e.g. Chevalier and Ellison (1997) and Palomino and Prat (2003)), they are beyond the scope of this paper.…”

Bonus Payments and Fund Managers' Behavior: Transatlantic Evidence

“…22 Eichberger et al (1999) show that relative performance contracts in the market may lead to inefficient outcomes as fund managers do not invest enough effort in getting (fundamental) information (see also Gümbel, 2005). Palomino and Prat (2003) derive that an optimal bonus contract should link the payment to the realization of a desired threshold portfolio return, whereas otherwise managers may follow too risky investment policies. Thus, theoretical studies derive unfavorable predictions about the impact of relative performance assessment on working effort, risk taking and the use of fundamental information, although Basak et al (2007) derive a positive effect by limiting extreme risk taking.…”

Non-Exclusive Financial Advice

“…Existing models highlight many important aspects of standard delegated portfolio management by studying how investors should optimally design contracts (remuneration schemes) for money managers. Following the moral-hazard tradition some of these models assume that the money manager chooses the riskiness and/or the expected return of his client's portfolio, and that this choice is unobservable to the investor, who then needs to design a second-best contract that motivates the expert to choose the right action (e.g., Adamati and P ‡eiderer, 1997; Stoughton, 1993;Palomino and Prat, 2003;and Palomino and Uhlig, 2006). In the adverse selection framework, Allen (1985) and Bhattacharya and P ‡eiderer (1985) are the …rst to propose models where a better informed advisor must be solicited to reveal superior information about the rate of return and/or the riskiness of a …nancial asset to an uninformed investor.…”