Convex Incentives and Liquidity Premia

57 Pages Posted: 21 Dec 2018 Last revised: 9 Apr 2021

See all articles by Min Dai

Min Dai

National University of Singapore

Luis Goncalves-Pinto

University of New South Wales (UNSW)

Jing Xu

Renmin University of China - School of Finance

Cheng Yan

Durham Business School

Date Written: April 10, 2021

Abstract

We show that convexity in investors' preferences can significantly amplify the effect of transaction costs on the liquidity premia of stocks. This result is derived from the dynamic portfolio problem of fund managers who engage in risk-shifting to capture year-end bonuses, but is robust to other sources of convexity such as loss aversion or status concerns. The larger premia compensate primarily for the lower bonuses resulting from the suboptimal implementation of risk-shifting strategies. Using data on actively-managed mutual funds, we provide empirical support for the novel predictions of our model.

Keywords: Mutual Funds, Convex Incentives, 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 (April 10, 2021). Available at SSRN: https://ssrn.com/abstract=3288875 or http://dx.doi.org/10.2139/ssrn.3288875

Min Dai

National University of Singapore ( email )

Singapore

Luis Goncalves-Pinto (Contact Author)

University of New South Wales (UNSW) ( email )

Kensington
High St
Sydney, NSW 2052
Australia

HOME PAGE: http://luis.goncalvespinto.com/

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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