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Asset Pricing under Optimal Contracts

43 Pages Posted: 9 Feb 2017 Last revised: 17 Oct 2017

Jaksa Cvitanic

California Institute of Technology - Division of the Humanities and Social Sciences

Hao Xing

London School of Economics & Political Science (LSE)

Date Written: October 9, 2017

Abstract

We consider the problem of finding equilibrium asset prices in a financial market in which a portfolio manager (Agent) invests on behalf of an investor (Principal), who compensates the manager with an optimal contract. We extend a model from Buffa, Vayanos and Woolley (2014) by allowing general contracts, and by allowing the portfolio manager to invest privately in individual risky assets or the index. To alleviate the effect of moral hazard, Agent is optimally compensated by benchmarking to the index, which, however, may incentivize him to be too much of a "closet indexer". To counter those incentives, the optimal contract rewards Agent for taking specific risk of individual assets in excess of the systematic risk of the index, by rewarding the deviation between the portfolio return and the return of an index portfolio, and the deviation's quadratic variation.

Keywords: Asset-Management, Equilibrium Asset Pricing, Optimal Contracts, Principal-Agent Problem

JEL Classification: C61, C73, D82, J33, M52

Suggested Citation

Cvitanic, Jaksa and Xing, Hao, Asset Pricing under Optimal Contracts (October 9, 2017). Available at SSRN: https://ssrn.com/abstract=2913836

Jaksa Cvitanic (Contact Author)

California Institute of Technology - Division of the Humanities and Social Sciences ( email )

1200 East California Blvd.
Pasadena, CA 91125
United States

HOME PAGE: http://www.hss.caltech.edu/~cvitanic/

Hao Xing

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

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