Optimal Contracts in Portfolio Delegation

50 Pages Posted: 14 Dec 2006 Last revised: 2 Jun 2016

See all articles by Tao Li

Tao Li

City University of Hong Kong (CityU) - Department of Economics & Finance

Yuqing Zhou

The Chinese University of Hong Kong (CUHK) - Department of Finance

Multiple version iconThere are 3 versions of this paper

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

Li, Tao and Zhou, Yuqing, Optimal Contracts in Portfolio Delegation (February 18, 2016). Available at SSRN: https://ssrn.com/abstract=951707 or http://dx.doi.org/10.2139/ssrn.951707

Tao Li (Contact Author)

City University of Hong Kong (CityU) - Department of Economics & Finance ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

Yuqing Zhou

The Chinese University of Hong Kong (CUHK) - Department of Finance ( email )

Shatin, N.T.
Hong Kong
+852 2609 7759 (Phone)
+852 2603 6586 (Fax)

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