Article1989

Adverse Risk Incentives and the Design of Performance-Based Contracts

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Financial Markets and Investment Strategies Stochastic processes and financial applications Risk and Portfolio Optimization

Abstract

This paper uses option pricing theory to value and analyze many performance-based fee contracts that are currently in use. A potential problem with some of these contracts is that they may induce portfolio managers to adversely alter the risk of the portfolios they manage. The paper is prescriptive in that it presents conditions for contract parameters that provide proper risk incentives for classes of investment strategies. For buy-and-hold and rebalancing strategies adverse risk incentives are avoided when the penalties for poor performance outweigh the rewards for good performance.

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References

1973The Pricing of Options and Corporate Liabilities 1968THE PERFORMANCE OF MUTUAL FUNDS IN THE PERIOD 1945–1964 1976The valuation of options for alternative stochastic processes 1978THE VALUE OF AN OPTION TO EXCHANGE ONE ASSET FOR ANOTHER 1979The valuation of compound options 1984Investment incentives, debt, and warrants 1979The Pricing of Contingent Claims in Discrete Time Models 1985Delegated portfolio management

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