Risk Taking and Optimal Contracts for Money Managers

Abstract

Recent ernpincal work suggests a strong connection between the incentives money maziagers are offered arrd their risk-taking behavior.We develop a general model of delegated portfolio management, with the feature that the agent can control the riskiness of the portfolio.This represents a departure from the existing literature on agency theory in that moral hazazd is not only effort exertion but also risk taking behavior.The tnoral hazard problem with risk taking involves an incentivecompatibility constraint on risk, which we chazacterize.We distinguish between one period and several periods.In the former case, under mild conditions, there exists a first-best contract which takes the form of a bonus contract.In the latter, we show that there exists no first-best contract and we use a numerical approximation to st udy the properties of the second-best contract.