Convex Incentives in Financial Markets: An Agent-Based Analysis
29 Pages Posted: 25 Nov 2014 Last revised: 26 Nov 2014
Date Written: November 24, 2014
This paper uses agent-based simulation to analyze how financial markets are affected by market participants with convex incentives, e.g. option-like compensation. We document that convex incentives are associated with (i) higher prices, (ii) larger variations of prices, and (iii) larger bid-ask spreads. We conclude that convex incentives may lead to decreased stability of financial markets. Our analysis suggests that the decreased stability is driven by the fact that convex incentives pushes agents towards more extreme decisions. Furthermore, while risk preferences affect agent behavior if they have linear incentives, the effect of risk preferences vanishes with convex incentives.
Keywords: incentives, market instability, agent-based simulations
JEL Classification: G10, D40, D53
Suggested Citation: Suggested Citation