Dynamic Asset Allocation with Hidden Volatility

50 Pages Posted: 23 Nov 2016 Last revised: 17 Jun 2018

Felix Zhiyu Feng

University of Notre Dame

Mark M. Westerfield

University of Washington

Date Written: June 10, 2018

Abstract

We study a continuous-time principal-agent model with endogenous cash-flow volatility. The principal supplies the agent with capital for productive use, but the agent can misallocate capital for private benefit and has private control over both project volatility and investment size. The optimal contract can yield either overly-risky or overly-prudent project selection. It can be implemented with a static two-part tariff on capital (fixed cost plus hurdle rate) while giving the agent control over the quantities of capital, risk, and equity share. Our model captures stylized facts about the use of hurdle rates and capital charges in practice.

Keywords: dynamic agency, volatility control, capital budgeting, cost of capital, continuous time

JEL Classification: D86, D82, G31

Suggested Citation

Feng, Felix Zhiyu and Westerfield, Mark M., Dynamic Asset Allocation with Hidden Volatility (June 10, 2018). Available at SSRN: https://ssrn.com/abstract=2874612 or http://dx.doi.org/10.2139/ssrn.2874612

Zhiyu Feng

University of Notre Dame ( email )

3079 Jenkins-Nanovic
Notre Dame, IN 46556
United States
(574)631-0428 (Phone)

HOME PAGE: http://felixzhiyufeng.weebly.com/

Mark M. Westerfield (Contact Author)

University of Washington ( email )

Box 353200
Seattle, WA 98195
United States

HOME PAGE: http://www.markwesterfield.com

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