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Moral Hazard and the Portfolio Management Problem



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    • University of California, Irvine. This paper was presented to seminar audiences at UCLA, U.C. Riverside, and the Western Finance Association. I would like to acknowledge helpful comments by Jeff Coles, an anonymous referee, and especially Masako Darrough. This research was partially supported by a U.C. Irvine faculty fellowship.


This paper investigates the significance of nonlinear contracts on the incentive for portfolio managers to collect information. In addition, the manager must be motivated to disclose this information truthfully. We analyze three contracting regimes: (1) first-best where effort is observable, (2) linear with unobservable effort, and (3) the optimal contract within the Bhattacharya-Pfleiderer quadratic class. We find that the linear contract leads to a serious lack of effort expenditure by the manager. This underinvestment problem can be successfully overcome through the use of quadratic contracts. These contracts are shown to be asymptotically optimal for very risk-tolerant principals.

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