Convex Incentives and Liquidity Premia

65 Pages Posted: 21 Dec 2018

See all articles by Min Dai

Min Dai

National University of Singapore (NUS) - Department of Mathematics

Luis Goncalves-Pinto

Chinese University of Hong Kong - Department of Finance

Jing Xu

Renmin University of China - School of Finance

Cheng Yan

Durham Business School

Date Written: December 3, 2018

Abstract

In the mutual fund industry, managerial contracts are typically incomplete and asymmetric due to convex flows and bonuses. This gives fund managers an incentive to gamble in response to beating their benchmarks. In the presence of transaction costs, gambling becomes expensive and less effective at capturing flows and bonuses. In equilibrium, fund managers demand high expected stock returns to compensate for the direct and indirect effects of transaction costs. This framework generates high turnover and large liquidity premia endogenously, while existing models require exogenous time-variation in investment opportunities. We provide empirical support for the novel implications of our theoretical model.

Keywords: Mutual Funds, Convex Flows, Bonuses, Transaction Costs, Liquidity Premia

JEL Classification: C61, D11, D91, G11

Suggested Citation

Dai, Min and Goncalves-Pinto, Luis and Xu, Jing and Yan, Cheng, Convex Incentives and Liquidity Premia (December 3, 2018). Available at SSRN: https://ssrn.com/abstract=3288875 or http://dx.doi.org/10.2139/ssrn.3288875

Min Dai

National University of Singapore (NUS) - Department of Mathematics ( email )

Singapore

Luis Goncalves-Pinto (Contact Author)

Chinese University of Hong Kong - Department of Finance ( email )

Cheng Yu Tung Building
Shatin
Hong Kong
Hong Kong

Jing Xu

Renmin University of China - School of Finance ( email )

59 Zhongguancun Street
Beijing, 100872
China

Cheng Yan

Durham Business School ( email )

Mill Hill Lane
Durham, Durham DH1 3LB
United Kingdom

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