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Risk taking and optimal contracts for money managers

Palomino, Frédéric and Prat, Andrea (1999) Risk taking and optimal contracts for money managers. 2066. Centre for Economic Policy Research, London, UK.

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Identification Number: 2066

Abstract

Recent empirical work suggests a strong connection between the incentives money managers are offered and their risk-taking behaviour. 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 behaviour. 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.

Item Type: Monograph (Discussion Paper)
Official URL: http://www.cepr.org
Additional Information: © 1999 Frédéric Palomino and Andrea Prat
Subjects: H Social Sciences > HG Finance
Sets: Collections > Economists Online
Departments > Economics
Research centres and groups > Suntory and Toyota International Centres for Economics and Related Disciplines (STICERD)
Date Deposited: 02 Jun 2008 09:33
Last Modified: 01 Oct 2010 08:54
URI: http://eprints.lse.ac.uk/id/eprint/5220

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