Incentives for Traders: Ideal and Heuristic Contracts (with Philip H. Dybvig)
Presented at University of Sydney (online), Wuhan University (Hubei, China).
Delegated expertise and full optimal contracting are two approaches used to study contracting with portfolio managers. However, neither approach is appropriate for contracting with traders, because both approaches assume separation of information gathering and execution of trades. We look instead at heuristic contracts based on what is readily observed, and we compare their efficiency to using the ideal contract that is unavailable. We find that the heuristic contract captures most of the efficiency gain. A convex quadratic reward for risk-taking is most useful for improving a linear contract. Adding a negative term proportional to realized variance of the underlying is also useful, because it makes it more costly to miss directional signals. Adding a convex quadratic reward for large portfolio returns is not useful, because it creates a bad incentive to take on arbitrarily large risk.
Impact of Systemic Risk Regulation on Optimal Policies and Asset Prices (with Carole Bernard), forthcoming at Journal of Banking and Finance