Working Paper: CEPR ID: DP2066
Authors: Frdric Palomino; Andrea Prat
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.
Keywords: money managers; risk; moral hazard; limited liability
JEL Codes: D82; G11; G24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Contract Type (L14) | Riskiness of Portfolio (G11) |
| First-Best Contract (D86) | Optimal Risk-Taking Behavior (D81) |
| Limited Liability (K13) | Excessive Risk-Taking (G41) |
| Second-Best Contracts (D86) | Higher Risk-Taking (D81) |