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Optimal delegation contract with portfolio risk

Author

Listed:
  • Sheng, Jiliang
  • Yang, Yanyan
  • Yang, Jun

Abstract

Conventional linear benchmarked contracts tend to cause excessive pegging to the benchmark and thus price distortion of stocks in the benchmark. This paper studies the optimal delegation contract when there is principal-agent friction. Specifically, it explores the impacts of incorporating the risk of invested portfolio in the contract on optimal strategies of the principal and the agent as well as on equilibrium asset prices. When agency friction is severe, the optimal contract provides rewards for portfolio risk to improve risk sharing and grants compensation for index return to propel the agent to deviate from pegging to index. In equilibrium, the principal conducts index investment while the agent invests only in individual risky assets, and price distortion caused by agency friction is mitigated.

Suggested Citation

  • Sheng, Jiliang & Yang, Yanyan & Yang, Jun, 2025. "Optimal delegation contract with portfolio risk," Journal of Banking & Finance, Elsevier, vol. 171(C).
    • Handle: RePEc:eee:jbfina:v:171:y:2025:i:c:s0378426624002711
    DOI: 10.1016/j.jbankfin.2024.107357
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    More about this item

    Keywords

    Optimal contract; Principal-agent friction; Risk compensation; Equilibrium asset price;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods

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