Working Paper: NBER ID: w12075
Authors: Gary B. Gorton; Ping He; Lixin Huang
Abstract: "Risk management" in securities markets refers to the oversight of portfolio managers and professional traders when they trade on behalf of investors in security markets. Monitoring of their trading performance, profit and loss, and risk-taking behavior, is measured by principals using security market prices. We study the optimality of the practice of marking-to-market and provide conditions under which investing principals should optimally monitor their agent traders using market prices to measure traders' performance. Asset prices, however, can be affected by mark-to-market contracts. We show that such contracts introduce an externality when there are many traders. Traders may rationally herd, trading on irrelevant information. Ironically, this causes asset prices to be less informative than they would be without the mark-to-market feature.
Keywords: risk management; mark-to-market; asset prices; trader behavior
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Mark-to-market contracts (G13) | Herding behavior among traders (C92) |
| Herding behavior (C92) | Decreased informativeness of asset prices (G19) |