Managerial Incentives and Financial Contagion
61 Pages Posted: 2 Jan 2004 Last revised: 26 Jan 2010
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Managerial Incentives and Financial Contagion
Managerial Incentives and Financial Contagion
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: Suggested Citation
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