Optimal Asset Allocation and Risk Shifting in Money Management

40 Pages Posted: 30 Jan 2006

See all articles by Suleyman Basak

Suleyman Basak

London Business School; Centre for Economic Policy Research (CEPR)

Anna Pavlova

London Business School; Centre for Economic Policy Research (CEPR)

Alex Shapiro

New York University (NYU) - Department of Finance

Multiple version iconThere are 3 versions of this paper

Date Written: May 2006

Abstract

This paper investigates a fund manager's risk-taking incentives induced by an increasing and convex fund-flows to relative-performance relationship. In a dynamic portfolio choice framework, we show that the ensuing convexities in the manager's objective give rise to a finite risk-shifting range over which she gambles to finish ahead of her benchmark. Such gambling entails either an increase or a decrease in the volatility of the manager's portfolio, depending on her risk tolerance. In the latter case, the manager reduces her holdings of the risky asset despite its positive risk premium. Our empirical analysis lends support to the novel predictions of the model. Under multiple sources of risk, with both systematic and idiosyncratic risks present, we show that optimal managerial risk shifting may not necessarily involve taking on any idiosyncratic risk. Costs of misaligned incentives to investors resulting from the manager's policy are demonstrated to be economically significant

Keywords: Fund Flows, Implicit Incentives, Risk Taking, Relative Performance, Risk Management, Portfolio Choice

JEL Classification: G11, G20, D60, D81

Suggested Citation

Basak, Suleyman and Pavlova, Anna and Shapiro, Alex, Optimal Asset Allocation and Risk Shifting in Money Management (May 2006). Available at SSRN: https://ssrn.com/abstract=879294 or http://dx.doi.org/10.2139/ssrn.879294

Suleyman Basak

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
44 (0)20 7000 8256 (Phone)
44 (0)20 7000 8201 (Fax)

HOME PAGE: http://www.suleymanbasak.com

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Anna Pavlova (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom
+44 20 7000 8218 (Phone)

HOME PAGE: http://faculty.london.edu/apavlova

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Alex Shapiro

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0362 (Phone)
212-995-4233 (Fax)

HOME PAGE: http://www.stern.nyu.edu/~ashapiro/

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