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Dynamic Asset Allocation with Hidden Volatility

55 Pages Posted: 23 Nov 2016 Last revised: 16 Jul 2017

Felix Zhiyu Feng

University of Notre Dame

Mark M. Westerfield

University of Washington

Date Written: December 12, 2016

Abstract

We study a dynamic continuous-time principal-agent model with endogenous cash flow volatility. The principal supplies the agent with capital for investment, but the agent can misallocate capital for private benefit and has private control over both the volatility of the project and the size of the investment. The optimal incentive-compatible contract can yield either overly risky or overly prudent project selection; it can be implemented as a time-varying cost of capital in the form of a hurdle rate. Our model captures stylized facts about the use of hurdle rates in capital budgeting and helps to reconcile the mixed empirical evidence on the correlations among firm size, risk and managerial compensation.

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

JEL Classification: D82, D86, G31, M52

Suggested Citation

Feng, Felix Zhiyu and Westerfield, Mark M., Dynamic Asset Allocation with Hidden Volatility (December 12, 2016). 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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