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Abstract:
Milton Friedman argued that irrational traders will consistently lose money, won't survive and, therefore, cannot influence long run asset prices. Since his work, survival and price impact have been assumed to be the same. In this paper, we demonstrate that survival and price impact are two independent concepts. The price impact of irrational traders does not rely on their long-run survival and they can have a significant impact on asset prices even when their wealth becomes negligible. We also show that irrational traders' portfolio policies can deviate from their limits long after the price process approaches its long-run limit. In contrast to a partial equilibrium analysis, these general equilibrium considerations matter for the irrational traders' long-run survival.

Irrational Traders, Price Impact, Price Influence, Survival, Irrationality, Long Run Prices

Abstract:
Milton Friedman argued that irrational traders will consistently lose money, won't survive and, therefore, cannot influence long run asset prices. Since his work, survival and price impact have been assumed to be the same. In this paper, we demonstrate that survival and price impact are two independent concepts. The price impact of irrational traders does not rely on their long-run survival and they can have a significant impact on asset prices even when their wealth becomes negligible. We also show that irrational traders' portfolio policies can deviate from their limits long after the price process approaches its long-run limit. In contrast to a partial equilibrium analysis, these general equilibrium considerations matter for the irrational traders' long-run survival.

Irrational Traders, Price Impact, Price Influence, Survival, Irrationality, Long Run Prices

Abstract:
Milton Friedman argued that irrational traders will consistently lose money, won't survive and, therefore, cannot influence long run equilibrium asset prices. Since his work, survival and price influence have been assumed to be the same. Often partial equilibrium analysis has been relied upon to examine the survival of irrational traders and to make inferences on their influence on prices. In this paper, we demonstrate that survival and influence on prices are two independent concepts. The price impact of irrational traders does not rely on their long-run survival and they can have a significant impact on asset prices even when their wealth becomes negligible. In addition, in contrast to a partial equilibrium analysis, general equilibrium considerations matter since the ability of irrational traders to impact prices even when their wealth is diminishing can significantly affect their chances for long-run survival. In sum, in a long-run equilibrium, we explicitly show that price impact can occur whether or not the irrational traders survive. In related work, we show that even if the irrational traders survive they may have no price impact.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
We study the optimal portfolio choice of hedge fund managers who are compensated by high-water mark contracts. Surprisingly, we find that even risk-neutral managers will not place unboundedly large weights on the risky assets, despite the option-type features of the contract. Instead they will place a constant fraction of assets in a mean-variance efficient portfolio and the rest in the riskless asset, similar to investors with constant relative risk aversion. This result is a direct consequence of the indefinite horizon of the contract. We argue more generally that the risk-seeking incentives of option-type compensation contracts rely on the interaction of convex compensation and finite horizons, rather than on the convexity of the compensation scheme alone.

Performance evaluation, Hedge funds, Option-type compensation, High-water marks, Continuous time

Abstract:
We study the optimal portfolio choice of hedge fund managers who are compensated by high-water mark contracts. Surprisingly, we find that even risk-neutral managers will not place unboundedly large weights on the risky assets, despite the option-type features of the contract. Instead they will place a constant fraction of assets in a mean-variance efficient portfolio and the rest in the riskless asset, similar to investors with constant relative risk aversion. This result is a direct consequence of the in(de)finite horizon of the contract. We argue more generally that the risk-seeking incentives of option-type compensation contracts rely on the interaction of convex compensation and finite horizons, rather than on the convexity of the compensation scheme alone.

Performance Evaluation, Hedge funds, Option-Type Compensation, High-Water Marks, Continuous Time

Abstract:
The hypothesis that financial markets punish traders who make relatively inaccurate forecasts and eventually eliminate the effect of their beliefs on prices is of fundamental importance to the standard modeling paradigm in asset pricing. We establish necessary and sufficient conditions for agents making inferior forecasts to survive and to affect prices in the long run in a general setting with minimal restrictions on endowments, beliefs, or utility functions. We show that the market selection hypothesis is valid for economies with bounded endowments or bounded relative risk aversion, but it cannot be substantially generalized to a broader class of models. Instead, survival is determined by a comparison of the forecast errors to risk attitudes. The price impact of inaccurate forecasts is distinct from survival because price impact is determined by the volatility of traders' consumption shares rather than by their level. Our results also apply to economies with state-dependent preferences, such as habit formation.

Market Selection, Heterogeneous Beliefs, State-Dependent Utility, Survival, Price Impact

Abstract:
We solve for the optimal dynamic contract when the manager can imperfectly divert cash flows and the principal can substitute direct monitoring for performance-based incentives. We show how to implement the contract using equity and debt. Debt contracts implement monitoring choices which relax the manager's incentive compatibility constraint, which in turn relaxes the firm's financing constraint. Consequently, the firm can recapitalize in distress without violating incentive compatibility (without giving the manager more opportunity to steal). Equity holders will choose the optimal equity issuance policy, contrary to the common intuitions underlying debt overhang and asset substitution arguments, because they do not wish their perpetually renewed call option on the firm to be terminated by bankruptcy. Our model shows how to dynamically recapitalize a firm, links the apparently unrelated debt covenant and equity issuance literatures, explains the frequency of distressed equity issues, complements the existing literature on managerial compensation, and makes several additional new testable predictions.

Optimal Financing, Monitoring, Debt Covenants, Equity Issuance

Abstract:
We present a dynamic contracting model in which the principal and agent disagree about the resolution of uncertainty, and we illustrate the contract design in an application with Bayesian learning. The disagreement creates gains from trade that the principal realizes by transferring payment to states that the agent considers relatively more likely, changing incentives. The interaction between incentive provision and learning creates an intertemporal source of "disagreement risk" that alters optimal risk sharing. There is an endogenous regime shift between economies with small and large belief differences, and an early shock to beliefs can lead to large persistent differences in variable pay even after beliefs have converged. Under risk-neutrality, "selling the firm" to the agent does not implement the first-best because it precludes state-contingent trades.

Dynamic Contracts, Heterogeneous Beliefs, Learning, Disagreement Risk, Principal-Agent, Continuous Time

Abstract:
We present a dynamic contracting model in which the principal and agent disagree about the resolution of uncertainty, and we illustrate the contract design in an application with Bayesian learning. The disagreement creates gains from trade that the principal realizes by transferring payment to states that the agent considers relatively more likely, changing incentives. The interaction between incentive provision and learning creates an intertemporal source of "disagreement risk" that alters optimal risk sharing. There is an endogenous regime shift between economies with small and large belief differences, and an early shock to beliefs can lead to large persistent differences in variable pay even after beliefs have converged. Under risk-neutrality, "selling the firm" to the agent does not implement the first-best because it precludes state-contingent trades.

Dynamic Contracts, Heterogeneous Beliefs, Learning, Disagreement Risk, Principal-Agent, Continuous Time

Abstract:
The hypothesis that financial markets punish traders who make relatively inaccurate forecasts and eventually eliminate the effect of their beliefs on prices is of fundamental importance to the standard modeling paradigm in asset pricing. We establish necessary and sufficient conditions for agents making inferior forecasts to survive and to affect prices in the long run in a general setting with minimal restrictions on endowments, beliefs, or utility functions. We show that the market selection hypothesis is valid for economies with bounded endowments or bounded relative risk aversion, but it cannot be substantially generalized to a broader class of models. Instead, survival is determined by a comparison of the forecast errors to risk attitudes. The price impact of inaccurate forecasts is distinct from survival because price impact is determined by the volatility of traders’ consumption shares rather than by their level. Our results also apply to economies with state-dependent preferences, such as habit formation.

Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Abstract:
We present a dynamic contracting model in which the principal and agent disagree about the resolution of uncertainty, and we illustrate the contract design in an application with Bayesian learning. The disagreement creates gains from trade that the principal realizes by transferring payment to states that the agent considers relatively more likely, changing incentives. The interaction between incentive provision and learning creates an intertemporal source of “disagreement risk” that alters optimal risk sharing. There is an endogenous regime shift between economies with small and large belief differences, and an early shock to beliefs can lead to large persistent differences in variable pay even after beliefs have converged. Under risk-neutrality, “selling the firm” to the agent does not implement the first-best because it precludes state-contingent trades.

D03, D86