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Rewarding Trading Skills Without Inducing Gambling

Author

Listed:
  • Igor Makarov

    (MIT Sloan - Sloan School of Management - MIT - Massachusetts Institute of Technology)

  • Guillaume Plantin

    (ECON - Département d'économie (Sciences Po) - Sciences Po - Sciences Po - CNRS - Centre National de la Recherche Scientifique, Tepper School of Business - CMU - Carnegie Mellon University [Pittsburgh])

Abstract

This paper develops a model of active asset management in which fund managers may forgo alpha-generating strategies, preferring instead to make negative-alpha trades that enable them to temporarily manipulate investors' perceptions of their skills. We show that such trades are optimally generated by taking on hidden tail risk, and are more likely to occur when fund managers are impatient and when their trading skills are scalable, and generate a high profit per unit of risk. We propose long-term contracts that deter this behavior by dynamically adjusting the dates on which the manager is compensated in response to her cumulative performance.

Suggested Citation

  • Igor Makarov & Guillaume Plantin, 2015. "Rewarding Trading Skills Without Inducing Gambling," SciencePo Working papers Main hal-01178107, HAL.
    • Handle: RePEc:hal:spmain:hal-01178107
    as

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    Cited by:

    1. Xing Gao & Daniel Ladley, 2022. "Noise trading and market stability," The European Journal of Finance, Taylor & Francis Journals, vol. 28(13-15), pages 1283-1301, October.
    2. Ewens, Michael & Gorbenko, Alexander & Korteweg, Arthur, 2022. "Venture capital contracts," Journal of Financial Economics, Elsevier, vol. 143(1), pages 131-158.
    3. Moreira, Alan, 2019. "Capital immobility and the reach for yield," Journal of Economic Theory, Elsevier, vol. 183(C), pages 907-951.
    4. Barron, Daniel & Georgiadis, George & Swinkels, Jeroen M., 2020. "Optimal contracts with a risk-taking agent," Theoretical Economics, Econometric Society, vol. 15(2), May.

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