Convex Incentives in Financial Markets: An Agent-Based Analysis

29 Pages Posted: 25 Nov 2014 Last revised: 26 Nov 2014

See all articles by Annalisa Fabretti

Annalisa Fabretti

University of Rome Tor Vergata - Tor Vergata Economics University Foundation

Tommy Garling

Göteborg University

Stefano Herzel

University of Rome Tor Vergata - Faculty of Economics

Martin Holmen

University of Gothenburg - Department of Economics; University of Gothenburg - Centre for Finance

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Date Written: November 24, 2014

Abstract

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

Fabretti, Annalisa and Garling, Tommy and Herzel, Stefano and Holmen, Martin, Convex Incentives in Financial Markets: An Agent-Based Analysis (November 24, 2014). Available at SSRN: https://ssrn.com/abstract=2529902 or http://dx.doi.org/10.2139/ssrn.2529902

Annalisa Fabretti

University of Rome Tor Vergata - Tor Vergata Economics University Foundation ( email )

Via Columbia 2
Rome, 00133
Italy

Tommy Garling

Göteborg University ( email )

Viktoriagatan 30
Göteborg, 405 30
Sweden

Stefano Herzel

University of Rome Tor Vergata - Faculty of Economics ( email )

Via Columbia n.2
Rome, rome 00100
Italy

Martin Holmen (Contact Author)

University of Gothenburg - Department of Economics ( email )

School of Business, Economics and Law
Box 640
Gothenburg, 40530
Sweden
+46 31 786 6442 (Phone)
+46 31 7865114 (Fax)

University of Gothenburg - Centre for Finance ( email )

Box 640
Gothenburg, 403 50
Sweden

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