Contracting for Financial Execution
51 Pages Posted: 24 May 2018 Last revised: 29 Mar 2019
Date Written: December 13, 2018
Financial contracts often specify reference prices whose values are undetermined at the time of contracting, which makes them prone to manipulation. To study such situations, we introduce a stylized model of financial contracting between a client, who wishes to trade a large position, and her broker. We find that a simple contract based on the volume-weighted average price (VWAP) emerges as the unique optimal solution to this principal-agent problem. This result explains the popularity of guaranteed VWAP contracts in practice and also suggests considerations for the optimal design of financial benchmarks.
Keywords: Agency Conflict, Benchmark Manipulation, Broker-Client Relationship, Foreign Exchange Fix, Front-Running, Pre-Trade Hedging, Volume-Weighted Average Price, VWAP
JEL Classification: G11, G14, G18, G23, D82, D86
Suggested Citation: Suggested Citation