Convex Incentives and Liquidity Premia

57 Pages Posted: 21 Dec 2018 Last revised: 24 Mar 2022

See all articles by Min Dai

Min Dai

The Hong Kong Polytechnic University; 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: March 22, 2022

Abstract

We show that convexities in investors' preferences significantly amplify the effect of transaction costs on liquidity premia. To maximize year-end bonuses, fund managers with negative benchmark-adjusted performance have an incentive to take excessive risks. However, trading costs hinder their ability to do so. Therefore, larger liquidity premia are required to compensate for increased turnover and lower bonuses ensuing from suboptimal risk-taking. These results are robust to alternative sources of convexity such as prospect theory and status concerns. Using data on actively-managed mutual funds, we provide empirical support for the novel predictions of our theoretical 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 (March 22, 2022). Available at SSRN: https://ssrn.com/abstract=3288875 or http://dx.doi.org/10.2139/ssrn.3288875

Min Dai

The Hong Kong Polytechnic University ( email )

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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