Managerial Incentives and Financial Contagion

61 Pages Posted: 2 Jan 2004 Last revised: 26 Jan 2010

See all articles by Sujit Chakravorti

Sujit Chakravorti

Chakra Advisors LLC

Subir Lall

International Monetary Fund (IMF)

Multiple version iconThere are 2 versions of this paper

Date Written: December 1, 2003

Abstract

This paper proposes a framework to examine the comovements of asset prices with seemingly unrelated fundamentals, as an outcome of the optimal portfolio strategies of large institutional fund managers. In emerging markets, the dominant presence of dedicated fund managers whose compensation is linked to the outperformance of their portfolio relative to a benchmark index, and of global fund managers whose compensation is linked to the absolute returns of their portfolios, leads to portfolio decisions that result in systematic interactions between asset prices even in the absence of asymmetric information. The model endogenously determines the optimal amount of cash holdings or leverage, the incidence of relative value versus macro hedge fund strategies, and how prices can systematically deviate from the long-term fundamental value for long periods of time, with limits to the arbitrage of this differential. Managerial compensation contracts, while optimal at a firm level, may lead to inefficiencies at the macroeconomic level. We identify conditions when a negative shock to one emerging market affects another market negatively.

Keywords: Financial Crises, Index Investors, Global Linkages

JEL Classification: F36, G11, G15

Suggested Citation

Chakravorti, Sujit and Lall, Subir, Managerial Incentives and Financial Contagion (December 1, 2003). Federal Reserve Bank of Chicago Research Paper Series, Forthcoming, Available at SSRN: https://ssrn.com/abstract=482865 or http://dx.doi.org/10.2139/ssrn.482865

Sujit Chakravorti (Contact Author)

Chakra Advisors LLC ( email )

3445 Deer Ridge Drive
Danville, CA 94506
United States

Subir Lall

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States
202 623 6113 (Phone)

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