Optimal Compensation for Fund Managers of Uncertain Type: Informational Advantages of Bonus Schemes

Performance-sensitivity of compensation schemes for portfolio managers is well explained by classic principal-agent theory as a device to provide incentives for managers to exert effort or bear the cost of acquiring information. However, the majority of compensation packages observed in reality display in addition a fair amount of convexity in the form of performance-related bonus schemes. While convex contracts may be explained by principal-agent theory in some rather specific situations, they have been criticized, both by the financial press as well as the academic literature, on the grounds that they may lead to excessive risk-taking. In this paper, we show that convex compensation packages, though likely to be myopically not optimal, may serve as a device to extract information about the ex-ante uncertain type of portfolio managers. Optimal contracts are thus determined by the trade-off between maximizing short-run expected returns on one hand, and long-run informational benefits on the other. In a discrete-time model, combining dynamic principal-agent theory with the theory of learning by experimentation, we characterize optimal incentive schemes and optimal retention rules for fund managers, consistent with empirical observations

The optimal use of return predictability : an empirical study

In this paper we study the economic value and statistical significance of asset return predictability, based on a wide range of commonly used predictive variables. We assess the performance of dynamic, unconditionally efficient strategies, first studied by Hansen and Richard (1987) and Ferson and Siegel (2001), using a test that has both an intuitive economic interpretation and known statistical properties. We find that using the lagged term spread, credit spread, and inflation significantly improves the risk-return trade-off. Our strategies consistently outperform efficient buy-and-hold strategies, both in and out of sample, and they also incur lower transactions costs than traditional conditionally efficient strategies

CAY revisited: can optimal scaling resurrect the (C)CAPM?

In this paper, we evaluate specification and pricing error for the Consumption (C-) CAPM in the case where the model is optimally scaled by consumption-wealth ratio (CAY). Lettau and Ludvigson (2001b) show that the C-CAPM successfully explains a large portion (about 70%) of the cross-section of expected returns on Fama and French’s size and book-to-market portfolios, when the model is scaled linearly by CAY. In contrast, we use the methodology developed in Basu and Stremme (2005) to construct the optimal factor scaling as a (possibly non-linear) function of the conditioning variable (CAY), designed to minimize the model’s pricing error. We use a new measure of specification error, also developed in Basu and Stremme (2005), which allows us to analyze the performance of the model both in and out-of-sample. We find that the optimal factor loadings are indeed non-linear in the instrument, in contrast to the linear specification prevalent in the literature. While our optimally scaled C-CAPM explains about 80% of the cross-section of expected returns on the size and book-to-market portfolios (thus in fact out-performing the linearly scaled model of Lettau and Ludvigson (2001b)), it fails to explain the returns on portfolios sorted by industry. Moreover, although the optimal use of CAY does dramatically improve the performance of the model, even the scaled model fails our specification test (for either set of base assets), implying that the model still has large pricing errors. Out-of-sample, the performance of the model deteriorates further, failing even to explain any significant portion of the cross-section of expected returns. For comparison, we also test a scaled version of the classic CAPM and find that it has in fact smaller pricing errors than the scaled C-CAPM

Market Volatility and Feedback Effects from Dynamic Hedging

In this paper we analyze in what way the demand generated by dynamic hedging strategies affects the equilibrium prices of the underlying asset. We derive an explicit expression for the transformation of market volatility under the impact of hedging. It turns out that market volatility increases and becomes price-dependent. The strength of the effects depend not only on the market share of portfolio insurance but also crucially on the heterogeneity of insured payoffs. We finally discuss in what sense hedging strategies calculated under the assumption of constant volatility are still appropriate, even if this assumption is obviously violated by their implementation.Black--Scholes Model, Dynamic Hedging, Volatility, Option Pricing, Feedback Effects

Pricing and hedging of derivative securities: Some effects of asymmetric information and market power.

This thesis consists of a collection of studies investigating various aspects of the interplay between the markets for derivative securities and their respective underlying assets in the presence of market imperfections. The classic theory of derivative pricing and hedging hinges on three rather unrealistic assumptions regarding the market for the underlying asset. Markets are assumed to be perfectly elastic, complete and frictionless. This thesis studies some effects of relaxing one or more of these assumptions. Chapter 1 provides an introduction to the thesis, details the structure of what follows, and gives a selective review of the relevant literature. Chapter 2 focuses on the effects that the implementation of hedging strategies has on equilibrium asset prices when markets are imperfectly elastic. The results show that the feedback effect caused by such hedging strategies generates excess volatility of equilibrium asset prices, thus violating the very assumptions from which these strategies are derived. However, it is shown that hedging is nonetheless possible, albeit at a slightly higher price. In Chapter 3, a model is developed which describes equilibrium asset prices when market participants use technical trading rules. The results confirm that technical trading leads to the emergence of speculative price "bubbles". However, it is shown that although technical trading rules are irrational ex-ante, they turn out to be profitable ex-post. In Chapter 4, a general framework is developed in which the optimal trading behaviour of a large, informed trader can be studied in an environment where markets are imperfectly elastic. It is shown how the optimal trading pattern changes when the large trader is allowed to hold options written on the traded asset. In Chapter 5, the results of the preceding chapter are used to study the interplay between options markets and the markets for the underlying assets when prices are set by a market maker. It turns out that the existence of the option creates an incentive for the informed trader to manipulate markets, which implies that equilibrium on both markets can only exist when option prices are adjusted to reflect this incentive. This requirement of price alignment explains the "smile" pattern of implied volatility, an empirically observed phenomenon that has recently been the focus of extensive research. Chapter 6 finally addresses recent proposals by some researchers suggesting that central banks should issue options in order to stabilise exchange rates. The argument, in line with the findings of Chapter 2, is based on the fact that hedging a long option position requires countercyclical trading that would reduce volatility. However, the results of Chapter 6 show that the option creates an incentive for market manipulation which, rather than protecting against speculative attacks, in fact creates an additional vehicle for such attacks. Chapter 7 concludes

Portfolio efficiency and discount factor bounds with conditioning information: a unified approach

In this paper, we develop a unified framework for the study of mean-variance efficiency and discount factor bounds in the presence of conditioning information. We extend the framework of Hansen and Richard (1987) to obtain new characterizations of the efficient portfolio frontier and variance bounds on discount factors, as functions of the conditioning information. We introduce a covariance-orthogonal representation of the asset return space, which allows us to derive several new results, and provide a portfolio-based interpretation of existing results. Our analysis is inspired by, and extends the recent work of Ferson and Siegel (2001,2002), and Bekaert and Liu (2004). Our results have several important applications in empirical asset pricing, such as the construction of portfolio-based tests of asset pricing models, conditional measures of portfolio performance, and tests of return predictability

Optimal Compensation for Fund Managers of Uncertain Type: The Information Advantages of Bonus Schemes

Performance-sensitivity of compensation schemes for portfolio managers is well explained by classic principal-agent theory as a device to provide incentives for managers to exert effort or bear the cost of acquiring information. However, the majority of compensation packages observed in reality display in addition a fair amount of convexity in the form of performance-related bonus schemes. While convex contracts may be explained by principal-agent theory in some rather specific situations, they have been criticized, both by the financial press as well as the academic literature, on the grounds that they may lead to excessive risk-taking. In this paper, we show that convex compensation packages, though likely to be myopically not optimal, may serve as a device to extract information about the ex-ante uncertain type of portfolio managers. Optimal contracts are thus determined by the trade-off between maximizing short-run expected returns on one hand, and long-run informational benefits on the other. In a discrete-time model, combining dynamic principal-agent theory with the theory of learning by experimentation, we characterize optimal incentives schemes and optimal retention rules for fund mangers, consistent with empirical observations.