Delegated Portfolio Management

13525 Words Jun 29th, 2013 55 Pages
Livio Stracca European Central Bank
Abstract. This paper provides a selective review of the theoretical literature on

delegated portfolio management as a principal–agent relationship. The main focus of the paper is to review the analytical issues raised by the peculiar nature of the delegated portfolio management relationship within the broader class of principal– agent models. In particular, the paper discusses the performance of linear versus nonlinear compensation contracts in a single-period setting, the possible effects of limited liability of portfolio managers, the role of reputational concerns in a multiperiod framework, and the incentives to noise trading.
…show more content…
Nonetheless, the outcome does not depend only on the agent’s effort, but also on environmental factors outside his control. The task of the landlord is to design a contract which encourages the best tenants to participate and, at the same time, gives the tenant the right incentives to work hard to achieve the result after the contract is signed. If the agent is risk neutral, the best contract makes the agent the residual claimant of the contract and the principal is paid a flat fee by the agent. These performancerelated contracts normally ensure that ‘good’ agents enter the contract and charlatans are left out, and at the same time provide the best incentives to the agent for expending costly effort. Moreover, if the principal is risk averse, the contract is also optimal for him from the standpoint of risk minimization. If, more realistically, the agent is risk averse and has no access to credit markets on the same terms as the principal, there is an obvious trade-off between inducing effort (which requires the agent to be exposed to the risky outcome) and providing insurance (which goes in the opposite direction). For this situation, the literature has reached two main results. First, it may be convenient for the principal to isolate the agent
Open Document