Convex Incentives and Liquidity Premia
57 Pages Posted: 21 Dec 2018 Last revised: 9 Apr 2021
Date Written: April 10, 2021
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: Suggested Citation