Optimal Contracts in Portfolio Delegation
50 Pages Posted: 14 Dec 2006 Last revised: 2 Jun 2016
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Optimal Contracts in Portfolio Delegation
Optimal Contracts in Portfolio Delegation
Date Written: February 18, 2016
Abstract
The optimal contracts in portfolio delegation under general preferences are characterized when the underlying state variable is not contractible, and the principal must rely on the final returns of portfolios to design the compensation schemes for the fund manager. We show that the optimal contracts satisfy a second-order nonlinear ordinary differential equation (ODE) that depends on the utility functions and the distribution of state price density. In general, there is an efficiency loss for the optimal contracts unless the utility functions of both the principal and the agent exhibit linear risk tolerance with identical cautiousness. Additional contractible observables, like stock indexes, can be used to improve the efficiency of the second-best contracts, even if they are not perfectly correlated with the underlying state price. A continuous-time example with power utilities is presented to illustrate the features of the optimal contracts.
Keywords: Benchmark, Risk Sharing, Incentive, Optimal Contract, Portfolio Delegation
JEL Classification: D80, G11, G30, J33, M52
Suggested Citation: Suggested Citation
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