Convex Incentives and Liquidity Premia
76 Pages Posted: 21 Dec 2018 Last revised: 24 Mar 2020
Date Written: March 24, 2020
We generate large liquidity premia endogenously from the interaction of transaction costs with convexity in preferences, offering a novel explanation for a longstanding puzzle. We derive this result from the dynamic portfolio problem of mutual fund managers facing either convex flows or year-end bonuses, but we show its robustness to other sources of convexity such as loss aversion or status concerns. We also provide empirical support for the main mechanism in our model, using the mutual fund scandal of 2003 as an exogenous shock to convex incentives to identify causal effects.
Keywords: Mutual Funds, Convex Flows, Bonuses, Transaction Costs, Liquidity Premia
JEL Classification: C61, D11, D91, G11
Suggested Citation: Suggested Citation