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com/abstract=951707
Optimal Portfolio Delegation with Imperfect
Information
∗
Tao Li
†
and Yuqing Zhou
‡
First Draft: December 2006
This Version: April 8, 2009
Abstract
This paper investigates the contracting problems that arise in portfolio delega
tion with imperfect information. In particular, this research studies the role of
stock indexes in the design of incentive fees in portfolio delegation. We show
that in a situation in which the fund manager possesses no superior security se
lection skill and the portfolio choices cannot be contracted upon, stock indexes
serve as important instruments for achieving optimal risksharing between the
investor and the fund manager. While the current literature mainly focuses on
the implications of benchmarking either for a given class of contract forms or for
a speciﬁc type of utility functions, we characterize the optimal contracts with
general preferences and incorporate stock indexes into the analysis. Our results
indicate that stock indexes can be used to recoup or reduce the eﬃciency loss
caused by the uncontractibility of portfolio choices, and can provide a valuable
service even if these indexes are imperfectly constructed.
Keywords: Benchmark, Risk Sharing, Incentive, Optimal Contract, Portfolio
Delegation
JEL Classiﬁcations: D80, G11, G30, J33, M52
∗
We would like to thank the seminar participants of Workshop in Contract Theory at CUHK (De
cember 2006), 2007 Econometric Society North American Summer Meetings and European Meetings
for helpful comments and suggestions.
†
Department of Economics and Finance, City University of Hong Kong, 83 Tat Chee Avenue,
Kowloon, Hong Kong, Email: taoli96@gmail.com.
‡
Department of Finance, Faculty of Business Administration, The Chinese University of Hong
Kong, Shatin, N.T., Hong Kong, Email: zhou@baf.msmail.cuhk.edu.hk.
Electronic copy available at: http://ssrn.com/abstract=951707
1 Introduction
The agency relationship arising in portfolio delegation and the resulting contracting
problems are quite diﬀerent from those studied by the classical principalagent the
ory. First, the fund manager’s action space may include both eﬀorts on information
collection and/or production and portfolio choices.
1
As Diamond (1998) has noted in
the context of the managerial compensation design, “Managers are called on to make
choices as well as to make eﬀorts.” This is especially relevant for delegated portfolio
management, in which the freedom of choices for the fund managers is much larger
than that faced by a ﬁrm manager. Thus the choice aspect is as important as, if not
more important than, the eﬀort dimension in the design of incentive fees in the in
vestment fund industry. Second, the wealth process of a managed portfolio has to be
endogenously determined through a well deﬁned trading strategy that satisﬁes budget
constraints. Thus one cannot arbitrarily assume an exogenous relation between the
actions and payoﬀs in portfolio delegation as a typical principalagent model does.
2
These issues make the standard principalagent models diﬃcult or impossible to
apply to the delegated portfolio management. Li and Zhou (2005), which characterizes
the secondbest contracts that can be written only on the ﬁnal wealth or return of
portfolios, is one of the ﬁrst attempts to move along this line. Built on Li and
Zhou (2005), this paper further investigates the contracting problems in portfolio
delegation with imperfect information. In particular, this research studies the role
of stock indexes in the design of incentive fees in the investment fund industry. The
model goes as follows. An investor, or a fund company, hires a fund manager to
1
The action space in the terms of portfolio choice can be very rich, e.g., in a continuoustime
setting. This richness of the agent’s action space has important implications on the structure of the
optimal compensation schemes, see, for instance, Diamond (1998) and Mirrlees and Zhou (2005a,
2005b).
2
This does cause some additional technical problems that are absent in the classical principal
agent model. This can be seen clearly from a model in a continuoustime setting, where, because of
the budget constraint, the drift rate and the diﬀusion rate of the underlying wealth process cannot
be controlled independently.
1
manage her portfolio. The fund manager has no superior security selection skill
3
in
the sense that she has no private information compared to other fund managers in the
market. We assume that the investor and fund manager share the same information
or belief about the security markets at aggregate level, which can be summarized
by assuming that both the investor and fund manager agree on the distribution of
the price density function in the case of complete markets. However, at the micro
level the fund manager does have better information than the investor about the
risk characteristics of individual securities, which partially justiﬁes the necessity of
portfolio delegation.
4
Given this, our model addresses the contracting problems in a
situation in which the fund manager does not have superior security selection skills
(compared to other fund managers, of course) and her portfolio choice cannot be
contracted upon. As a result, in designing incentive fees, the investor must rely on
other variables, say stock indexes, to motivate the fund manager to make the right
choice.
We show that the ﬁrstbest results are always achievable if there is a market
portfolio, which is, by deﬁnition, perfectly correlated with the underlying state price.
Hence the role of the market portfolio in portfolio delegation is to recoup the eﬃciency
loss due to the diﬀerent preferences between the investor and her fund manager.
However, the market portfolio may not be observable hence cannot be contracted upon
in reality, thus at best some imperfect observables, e.g., a stock index, can be used
in the design of the pay schemes for fund managers. In this case, the eﬃciency loss
of the secondbest contracts cannot be eliminated completely and the improvement
of eﬃciency depends on how well the index correlates with the market portfolio or
state price. We characterize the secondbest contracts with imperfect information
under rather general conditions by an integral equation, which can be solved by
piecewise ordinary diﬀerential equations (ODEs). Overall, our results shed light on
3
One of the reasons why a manager who possesses no superior skill is needed is the opportunity
costs for investors to constantly monitor the markets and trade in a continuoustime setting, see
Mamaysky and Spiegel (2002) for more elaborations on this.
4
It is much less costly to collect market data on information at aggregate level than at micro
level. In fact, as shown in this paper, all investors need to achieve the ﬁrstbest results is the market
portfolio, if it is observable hence can be contracted upon.
2
and identify another role of stock indexes in the compensation of fund managers: it is
used to recoup or reduce the eﬃciency loss of the secondbest contracts. This function
of stock indexes played in fund managers’ compensations has been largely ignored in
the literature.
There are several important aspects that justify our model’s assumptions and
conﬁrm their empirical relevance. First, there is extensive empirical evidence showing
that, historically, the majority of fund managers fail to beat the market, even if many
of them claim to be “active” fund managers. Thus, the assumption that the fund
manager has no superior security selection skills has some empirical relevance in
practice. Second, in reality, the structure of a fund manager’s compensation mainly
depends on the past performance of the fund under management, on the fund’s total
return relative to a prespeciﬁed benchmark, and on bonuses that are related to the
proﬁtability of the ﬁrm that employs her (see, e.g., Chevalier and Ellison (1997)
and Farnsworth and Taylor (2006)). While investors may place some restrictions on
the fund manager’s portfolio choice, the fund manager has large freedom in trading
assets in the markets and her incentive fees are seldom based on trading strategies
directly. As a result, it is reasonable to treat the fund manager’s portfolio choice as a
moral hazard variable, and to treat the conﬂicts of interest arising from the diﬀerent
preferences between the investor and fund manager as a fundamental issue in the
fund management industry. Third, although our model only deals with a simple
agency relationship, that is, an investor versus a fund manager, our analysis has
general implications to the situation where investors (or fund companies) hire many
managers simultaneously.
5
For example, the case of multiple fund managers can be
made precise when investors’ utility is exponential and the asset classes managed
by diﬀerent fund managers are relatively independent. Finally, our model conﬁrms
the popular view held by practitioners that the use of benchmarks can be valuable,
5
In reality, the agency relationship is multilayer and complex. In general, investors (or fund
companies) allocate their capital (usually under the recommendation of agents) among many diﬀerent
fund managers. However, the simple onetoone agency relationship considered in our model will
not disappear, and investors (or fund companies) still have to face the individual fund manger’s
incentive problem after the asset allocation decision has been made.
3
but may be for a diﬀerent reason. In our context, the stock indexes are valuable
because they can be used to recoup or reduce the eﬃciency loss caused by the fund
manager’s portfolio choice, and not to induce the fund manager’s eﬀorts in collecting
information. As a direct application, our model is mostly relevant to a wide range of
“passively” managed funds, the major objective of which is to balance the portfolio’s
risk and return that align with investors’ preferences and the managers of which need
a right incentive to do so.
Overall, we believe that the problem arising from the conﬂicts of interest due to
the diﬀerent preferences between the investors and fund managers is among the most
fundamental ones in the fund management industry. It has to be fully addressed in
the ﬁrst place before a fullﬂedged theory of portfolio delegation can be developed.
Our results indicate that a properly constructed stock index that is independent of
preferences can solve or at least mitigate these conﬂicts of interest. Interestingly,
some benchmarks already available in the markets exhibit some required features of
the theoretically constructed market index, and thus can be used to align the interest
of the fund manager with that of the investors to achieve optimal or near optimal
risksharing. As a result, our model has set up a foundation upon which further moral
hazard variables can be introduced to enrich the model.
On the technical side, we follow the method developed by Li and Zhou (2005) to
solve the optimal contract with imperfect information. Similar to Li and Zhou (2005),
we show that the problem of ﬁnding the optimal contract can be converted into the
one that solves a nonlinear secondorder ordinary diﬀerential equation (ODE). As a
result, the ﬁrst and secondbest contracts can be fully analyzed and compared. We
show that, for a given stock index, the ﬁrstbest risk sharing can be achieved if and
only if the stock index is perfectly correlated with the state price. In particular, when
the investor and fund manager have “similar” preferences, an incentive fee based
on ﬁnal wealth alone is suﬃcient to achieve the ﬁrstbest risk sharing (see Li and
Zhou (2005)). In case the stock index is imperfectly constructed or a market index is
impossible to construct, numerical calculation shows that the eﬃciency loss is small
if the market index is highly correlated to the price density function.
4
There are a number of papers that study the role of benchmarking in diﬀerent
contexts. Most of them focus on the eﬀects of benchmarking on the fund manager’s
trading strategy for a given class of compensation schemes (see Roll (1992) and Basak,
Pavlova, and Shapiro (2003) and the reference therein), and the predictions are mixed.
Stoughton (1993) and Admati and Pﬂeiderer (1997) study the adverse consequences
of benchmarking in the presence of private information for a given class of compensa
tion schemes, and show that in general the use of benchmarks will not induce the fund
manager to exert high eﬀorts in collecting information. OuYang (2003) and Dybvig,
Farnsworth, and Carpenter (2004) treat the compensation scheme with benchmarks
endogenously but focus on speciﬁc utilities. In contrast, we solve the optimal compen
sation scheme with imperfect information and general preferences in the secondbest
world. Kraft and Korn (2004) also consider the role of the market portfolio played in
the fund managers’ compensations. However, they mainly focus on the the ﬁrstbest
cases and do not characterize the secondbest contracts when the market portfolio is
unobservable and hence cannot be contracted upon.
The paper is organized as follows. The next section studies the contracting prob
lem with imperfect information in an abstract setting. The second and ﬁrstbest
contracts conditional on some signals are characterized in Section 3. The relation
between the eﬃciency and the quality of information is also discussed in this section.
Section 4 oﬀers a detailed example in a continuoustime setting, in which some fea
tures and implications of the optimal, especially the secondbest, contracts are further
studied. Section 5 concludes the paper. All proofs are provided in the appendix.
2 The Basic Framework
Consider a setting in which an investor or a fund company (the principal) wishes
to hire a fund manager (the agent) to manage her portfolio. The portfolio return is
realized over a continuum of states in a single period. Let (Ω, F, P) be the space
of states endowed with a probability measure and ω ∈ Ω be a state. As a start,
we assume that there exists a rich set of ﬁnancial securities such that the ﬁnancial
5
markets under consideration are complete. If a market is complete, then there exists a
unique state price function p (ω) per unit probability over Ω. The portfolio returns are
aﬀected by the agent’s actions, or individual security selections in the portfolio. Thus,
the incentive scheme designed by the principal matters in order to motivate the agent
to act in the best interest of the principal. If the agent’s action can be observed, or,
if the principal can costlessly distinguish the payoﬀ characteristics of the universe of
securities in the ﬁnancial markets, then the contracting problem between the principal
and the agent would be relatively straightforward; the contract would simply specify
the exact portfolio of securities to be selected by the agent and the compensation
that the principal promises to provide in return should the order be followed exactly.
However, if it is too costly for the principal to distinguish the payoﬀ characteristics of
the universe of securities, then the contract can no longer specify the agent’s security
selection in an eﬀective manner. Under this circumstance, the principal must design
a compensation scheme in a way that indirectly gives the agent an incentive to select
the correct set of securities. Li and Zhou (2005) study a case in which the only way
for the principal to get the agent to select a correct portfolio is to relate her pay to
the realization of the portfolio return, which is random. In this paper, we focus on
the use of imperfect information for the eﬃciency improvement of the contract.
To be more speciﬁc, let w ≥ 0 be the ﬁnal wealth of the selected portfolio and
w(ω) be the realization of the ﬁnal wealth over Ω, which is observable. In addition,
a signal s(ω), possibly vector valued, can be observed by both the principal and
the agent (common knowledge and veriﬁable), and can consequently be contracted
upon. A compensation scheme speciﬁes the agent’s wage as a function of the observed
ﬁnal wealth and the signal y(w, s). Let the principal’s utility function be u(·) and
the agent’s utility be v (·) , where u(·) and v(·) are independent of states, increasing
and concave over the interval [0, ∞). We also assume that the utilities are twice
diﬀerentiable,
6
and their ﬁrstorder derivatives satisfy u
(∞) = v
(∞) = 0. If the
ﬁnal wealth is w, the net beneﬁt for the principal is assumed to be α(w, s) −y(w, s),
where 0 < α(w, s) ≤ w. When α(w, s) = w, our model is a typical principalagent
problem. It can be interpreted as a large investor hiring a money manager to manage
6
The diﬀerentiability are not necessary but for convenience.
6
his portfolio.
7
In general, α(w, s) is used to model a situation in which the principal
may be an institution or may act as an agent of large number of investors, and
thus only receive a portion of the realization of the ﬁnal wealth either explicitly as a
management fee (e.g., a contract between a fund company and investors) or implicitly
through the ﬂow of new funds.
The principal will delegate an initial wealth w
0
for the agent to manage, and
design a pay schedule y (w, s) to induce the agent to act in her best interest. Given
a compensation scheme y (w, s) , under the budget constraint, the agent will select a
portfolio such that his own expected utility is maximized. Therefore, there exists an
explicit conﬂict of interests between the principal and the agent, and it is interesting
to see how the principal and the agent share the risks and what the optimal contracts
are. To formalize these ideas, let the agent’s action space A be deﬁned by
A = {w(ω) ≥ 0
Ω
p(ω)w(ω)dP(ω) ≤ w
0
}, (1)
where the last term in equation (1) is the budget constraint. In other words, the action
space A consists of all random variables over Ω that satisfy the budget constraint.
In contrast to those onedimensional (or lowdimensional) action spaces studied in
the agency models in existing literature, ours is “large” in the sense that it is inﬁnite
dimensional. Let the agent’s reservation utility be v
0
. Formally, the model goes as
follows:
max
y(w,s),w(ω)
Ω
u(α(w, s) −y(w, s)) dP(ω) (2)
subject to
Ω
v(y(w, s)) dP(ω) ≥ v
0
(3)
and
w(ω) ∈ arg max
ˆ w(ω)∈A
Ω
v(y( ˆ w(ω), s)) dP(ω), (4)
where equations (3) and (4) are the standard participation constraint and incentive
constraint, respectively. The solution y(w, s) to this contract problem is the second
7
Much work in this literature has been done under such a speciﬁcation. See Dybvig, Farnsworth,
and Carpenter (2004) and the references therein.
7
best, whereas the solution y(w, s) to (2) and (3) only is the ﬁrst best that is Pareto
eﬃcient.
The contracting problem above can be rewritten in terms of distribution condi
tional on the signal s.
max
y(w,s),w(ω)
ds f
s
(s)
Ω
u(α(w, s) −y(w, s)) dP(ωs) (5)
subject to
ds f
s
(s)
Ω
v(y(w, s)) dP(ωs) ≥ v
0
(6)
and
w(ω) ∈ arg max
ˆ w(ω)∈A
ds f
s
(s)
Ω
v(y( ˆ w(ω), s)) dP(ωs), (7)
where P(ωs) is the conditional distribution on s and the agent’s action space is
rewritten as
A = {w(ω) ≥ 0
ds f
s
(s)
Ω
p(ω)w(ω)dP(ωs) ≤ w
0
}. (8)
For the case in which no signal s is involved in the pay schedule y, the contracting
problem (5)(7) is studied in Li and Zhou (2005). Following Li and Zhou (2005), we
reformulate the model in terms of distributions. We note that, given our model setup
in that both the principal’s utility and the agent’s utility are independent of state ω,
it is wellknown, in the literature of portfolio choice without agency problem, that the
states only need to be distinguished by the state price p and the signal s when the
ﬁnancial markets are complete. This is also true for portfolio delegations. We will
use f and F as probability density and cumulative distribution functions, respectively
and use subscripts to distinguish diﬀerent variables. Speciﬁcally, let f
s
and f
p
be the
density functions of signal s and state price p, and write the joint distribution of p
and s as f
s
(s)f
ps
(p), where f
ps
(p) is the conditional probability density of state price
p on s. Also let f
w
(w) be the distribution functions of wealth w(ω). Note that f
s
, f
p
,
hence f
ps
are exogenously given, whereas f
w
(w) is the agent’s choice variable. For
simplicity, we further assume f
ps
is continuous and ﬁrstorder diﬀerentiable.
8
8
These assumptions are not crucial to solve the contracting problems, but rather for convenience.
In addition, the state price density functions can not be arbitrarily speciﬁed; there should be no
arbitrage opportunity. Relevant restrictions are given explicitly when we work with speciﬁc examples.
8
Now deﬁne feasible action spaces in the terms of state price and wealth distribution
as
A
p
= {w(p, s) ≥ 0
ds f
s
(s)
pw(p, s)f
ps
(p) dp ≤ w
0
} (9)
and
A
w
= {f
ws
(w) ≥ 0
ds f
s
(s)
F
−1
ps
(1 −F
ws
(w))wf
ws
(w) dw ≤ w
0
}, (10)
where we have used the following
p = F
−1
ps
(1 −F
ws
(w)), (11)
to rewrite the budget constraint in terms of wealth distribution. Equation (11) implies
that that w is a nonincreasing function of p that reduces the size of the agent’s action
space, and seems to be restrictive. However, the optimal choice is always within the
agent’s action space A
w
, as shown by the following lemma.
Lemma 1 Take an arbitrary utility function G(w, s) such that
max
w(ω)∈A
Ω
G(w(ω), s(ω)) dP(ω)
exists. Then
max
w(ω)∈A
ds f
s
(s)
Ω
G(w(ω), s) dP(ωs)
= max
w(p,s)∈A
p
ds f
s
(s)
G(w(p), s)f
ps
(p) dp
= max
f
ws
(w)∈A
w
ds f
s
(s)
G(w, s)f
ws
(w) dw,
where A
p
and A
w
are deﬁned in equations (9) and (10), respectively.
Notice that the optimizations are pointwise in the dimension of the signal s. Based
on this observation, Lemma 1 is a straightforward extension of a similar result in Li
and Zhou (2005) without a signal or information.
Now Lemma 1 enables us to reformulate the agent’s problem in the terms of wealth
distribution, hence the principal’s problem represented by equations (5)(7) can be
9
reformulated as follows:
max
y(w,s),f
ws
(w)
ds f
s
(s)
u(α(w, s) −y(w, s))f
ws
(w)dw (12)
subject to
ds f
s
(s)
v(y(w, s))f
ws
(w) dw ≥ v
0
(13)
and
f
ws
(w) ∈ arg max
ˆ
f
ws
(w)∈A
w
ds f
s
(s)
v(y(w, s))
ˆ
f
ws
(w) dw (14)
To solve the principalagent problem (12)(14), the method we are going to use
here is the basic technique in the calculus of variations. The basic idea goes as follows.
Suppose that f
ws
(w) is an optimal solution, then perturb f
ws
(w) by (s) η (w, s),
where (s) is a small constant for each s and η is an arbitrary integrable function that
satisﬁes
η(w, s) dw = 0 for each s. Such a restriction makes sure
ds f
s
(s)
[f
ws
(w)+
η(w, s)] dw = 1. This is analogous to the ﬁnite dimensional case, in which η is a di
rectional vector. The fact that f
ws
is an optimal solution implies that all directional
derivatives at f
ws
for each s are zero. The details for applying this technique are
provided in Li and Zhou (2005).
To solve the principal’s contracting problem, we ﬁrst need to solve the agent’s
problem, the resulting Lagrange of which is
V(f
ws
, λ, λ
f
) =
ds f
s
(s)
v(y(w, s))f
ws
(w) dw
−λ
¸
ds f
s
(s)
f
ws
(w)F
−1
ps
(1 −F
ws
(w))wdw −w
0
+
ds f
s
(s)
λ
f
(w, s)f
ws
(w) dw, (15)
where λ is positive constant and λ
f
is a nonnegative function of wealth w and sig
nal s, which is equal to zero if f
ws
(w) > 0. As indicated by the Lagrange V, the
maximization over signal s can be done statebystate or point maximization. This
observation simpliﬁes the problem signiﬁcantly. That is, for each s, the agent’s prob
10
lem is equivalent to choosing f
ws
(w) to maximize
v(y(w, s))f
ws
(w) dw + λ
¸
f
ws
(w)F
−1
ps
(1 −F
ws
(w))wdw −w
0
+
λ
f
(w, s)f
ws
(w) dw.
This problem is similar to what has been studied in Li and Zhou (2005).
Lemma 2 Given a pay schedule y(w, s). Suppose the agent’s problem has an optimal
solution.
9
Then the necessary and suﬃcient condition for optimality is that, for any
s, there exist constants, λ > 0, λ
(s), and a density function f
ws
(w) ≥ 0 such that
˜ x(w, s) ≡ λ
w
F
−1
ps
(1 −F
ws
(t)) dt + λ
(s), (16)
where ˜ x(w, s) is the concaviﬁcation of the agent’s utility function v(y(w, s)) and is an
arbitrary number such that f
ws
> 0. Furthermore, f
ws
(w) ≡ 0 for w ∈ {tv(y(t, s)) =
˜ x(t, s)}.
An immediate implication of Lemma 2 is that we can restrict our feasible pays
that make the agent’s indirect utility x(w, s) = v(y(w, s)) concave in w. All other
feasible pay schedules have an equivalent “concave” pay that is diﬀerent only on the
set of f
ws
= 0. This observation enables us to further simplify the principal’s problem
by replacing the incentive constraint by equation (16). Lemma 2 makes it legitimate
to use the ﬁrstorder approach in solving the contracting problem.
Speciﬁcally, let x(w, s) = v(y(w, s)), therefore, y(w, s) = v
−1
(x) = h(x(w, s)) for
ﬁxed s. Since v (y) is increasing and concave, h(x) is increasing and convex. The
principal’s problem is then reformulated as follows
10
max
x,f
ws
∈A
w
dsf
s
(s)
u(α(w, s) −h(x(w, s)))f
ws
(w) dw (17)
9
For example, if y(w, s) is bounded above by a linear function for all s, then x(w, s) will have an
optimal solution.
10
The signals in α and in pay schedule y could be diﬀerent. In this case, the contracting problem
can be solved by perturbing f
ws
1
,s
2
and f
s
becomes a joint distribution of s
1
and s
2
.
11
subject to
x(w, s) = λ
w
F
−1
ps
(1 −F
ws
(t)) dt + λ
(s), (18)
where λ > 0 and λ
(s) are free variables, which are constrained by
ds f
s
(s)
x(w, s)f
ws
(w)dw ≥ v
0
. (19)
The reformulation of the original problem leads to equations (17)(19), in which
the principal selects x(w, s) and f
ws
(w) to maximize his utility u subject to the
ﬁrstorder condition constraint (18) plus the participation and budget constraints.
Indeed, x (w, s) and its concaviﬁcation ˜ x(w, s) are identical in a distribution sense,
which is exactly what matters in our principalagent problem. If x (w, s) is concave
and nondecreasing for each s, then x (w, s) = ˜ x (w, s) . Equation (18) alone also reveals
an important feature of the optimal contract. That is, the optimal contract must be
designed in such a way that the compensation is a nondecreasing function of the ﬁnal
wealth. Of course, to obtain additional features of the optimal contract, we need to
solve the principal’s maximization problem. Lemma 2 tells us that the principal only
needs to focus on the class of nondecreasing and concave functions in the selection of
x (w, s).
Our discussions so far lead us to conclude that, on the one hand, for any smooth,
increasing and concave indirect function x(w, s) and a number λ > 0 there exists a
distribution function
F
ws
(w) = 1 −F
ps
(
1
λ
x
(w, s)) (20)
such that equation (18) is satisﬁed. In other words, for any x(w, s), there is a unique
f
ws
(w) that implements it. On the other hand, for any distribution function f
ws
(w)
and λ > 0, there exists a unique x(w, s) that satisﬁes equations (18) and (19).
12
3 The Optimal Contracts
3.1 The SecondBest Contracts
In this section we characterize the optimal contracts of the agency problem discussed
in the previous section. Deﬁne
U
s
(f
ws
, λ, λ
, λ
w
, λ
v
, λ
f
) =
u(α(w, s) −h(x(w, s))) f
ws
(w) dw
−λ
w
¸
f
ws
(w)F
−1
ps
(1 −F
ws
(w))wdw −w
0
+λ
v
¸
x(w, s)f
ws
(w) dw −v
0
+
λ
f
(w, s)f
ws
(w) dw, (21)
where λ > 0, λ
w
> 0, λ
v
≥ 0, and λ
f
(w, s) ≥ 0 if f
ws
(w) = 0. The Lagrangian for
the principal’s maximization problem is
U(f
ws
, λ, λ
, λ
w
, λ
v
, λ
f
) =
U
s
(f
ws
, λ, λ
, λ
w
, λ
v
, λ
f
)f
s
(s) ds.
This means that maximizing U is equivalent to maximizing U
s
for all s.
Note that, in addition to the budget and the individual rationality constraints, the
objective function U is also dependent on two choice variables λ and λ
(s). These two
variables can be handled separately from the function f
ws
(w) by point maximization.
Proposition 1 For any given multipliers λ
w
and λ
v
, and a density function f
ws
(w),
the objective function U is a concave function of (λ, λ
(s)). At optimum, (λ, λ
(s))
must satisfy the following ﬁrstorder conditions
∂U
∂λ
= −
1
λ
ds f
s
(s)
f
ws
(w)[x(w, s) −λ
(s)][u
h
−λ
v
] dw = 0, (22)
∂U
∂λ
(s)
= −
f
ws
(w)[u
h
−λ
v
] dw = 0 (23)
for all s. In addition, the last equation implies λ
v
> 0, that is, the participation
constraint must be binding at optimum.
13
To determine f
ws
, we use a variational technique as illustrated in the case of the
agent’s problem.
Proposition 2 Fixed (λ
w
, λ
v
, λ, λ
(s)). The ﬁrstorder necessary condition for an
optimal solution f
ws
to the contract problem is that there exists a function c(s) such
that
u(α(w, s) −h(x(w, s))) + λ
f
(w, s) +
λ
v
−
λ
w
λ
x(w, s)
+λ
w
1
f
ps
(p)
a
0
(u
h
−λ
v
)f
ws
(t) dt
da = c(s) (24)
holds almost everywhere, where p = F
−1
ps
(1 −F
ws
(a)).
As shown in Li and Zhou (2005), this condition can handle corner solutions quite
easily, e.g., α is discontinuous and/or nondiﬀerentiable at some points. However, to
ease the exposition, we only focus on the interior solutions in this paper.
For the region(s) in which λ
f
(w, s) = 0, a diﬀerential equation can be derived
to further investigate the property of the optimal solutions. Taking derivatives with
respect to w to the ﬁrstorder condition (24) implies that
d[u + (λ
v
−λ
w
/λ) x]
dw
+
λ
f
ps
(p)
w
0
[u
h
−λ
v
]f
ws
(t) dt = 0, (25)
where p = F
−1
ps
(1 −F
ws
(w)). This diﬀerentialintegral equation becomes an ordinary
diﬀerential equation by taking derivatives one more time and using the fact that
f
ws
(w) = −
1
λ
f
ps
(x
/λ)x
.
Deﬁne
D(s) = {wβ −2u
h
+ (u
[α
−h
x
] + (β −λ
v
)x
)
f
ps
λf
ps
< 0}, (26)
where β = 2λ
v
−λ
w
/λ and the prime denotes the derivatives with respect to w.
Proposition 3 Suppose u(α(w, s) − h(x)) is a concave function of (w, x) for all s.
Then λ
f
(w, s) ≡ 0 for all (w, s).
14
In addition, the agent’s indirect utility, x = v(y), satisﬁes the following ordinary
diﬀerential equation (ODE)
[β −2u
h
] x
+ u
[α
−h
x
]
2
−u
h
[x
]
2
+ u
α
+x
(u
[α
−h
x
] + (β −λ
v
)x
)
f
ps
(p)
λf
ps
(p)
= 0, (27)
which has a unique solution in D(s), given a set of boundary conditions (x(), x
()),
where p = x
/λ, where α
is the ﬁrstorder derivative with respect to w.
The optimal pay schedule y also satisﬁes an ordinary diﬀerential equation (ODE)
as:
(βv
−2u
)y
+
v
v
(βv
−u
)[y
]
2
+ u
[α
−y
]
2
+ u
α
+
v
y
+ v
[y
]
2
(u
[α
−y
] + (β −λ
v
)v
y
)
f
ps
(p)
λf
ps
(p)
= 0, (28)
where p = v
y
/λ. However, it seems to be easier to work with the agent’s indirect
utility x. The contracting problem can be solved by solving the ODE (27) and the
multipliers are determined by the following integrals.
The ﬁrstorder conditions for (λ, λ
(s)) in equations (22) and (23) can be rewritten
as follows
ds f
s
(s)
∞
0
f
ps
(x
/λ)x
x[u
h
−λ
v
] dw = 0, (29)
and
∞
0
f
ps
(x
/λ)x
[u
h
−λ
v
] dw = 0, (30)
for each s. And the budget and participation constraints become
ds f
s
(s)
∞
0
wf
ps
(x
/λ)x
x
dw = −λ
2
w
0
(31)
and
ds f
s
(s)
∞
0
f
ps
(x
/λ)x
xdw = −λv
0
. (32)
When we have solved for x(w, s), the optimal pay schedule is given by y = h(x(w, s)).
15
3.2 The FirstBest Contracts
It is clear that the secondbest contracts are equivalent to the ﬁrstbest one if the
signal s is the same as the underlying state ω. The ﬁrstbest contract consists of a
ﬁnal wealth function w(ω), which is equivalent to a detailed instruction of portfolios,
and a pay schedule y(ω) such that the pair (w(ω), y(ω)) maximizes the principal’s
expected utility under the budget constraint:
max
w(ω)∈A, y(ω)
Ω
u(α(w(ω), s) −y(ω)) dP(ω) (33)
subject to the participation constraints:
Ω
v(y(ω)) dP(ω) ≥ v
0
. (34)
This maximization problem is straightforward when u(α(w, s) −y) is concave for all
s and y, but it becomes complicated when α(w, s) is convex. Therefore, it is helpful
to reformulate the problem into the principal’s choosing the distribution of wealth f
w
instead of w. However, we cannot directly apply Lemma 1 to transform the problem
into choosing f
w
because of the additional term y(ω).
Lemma 3 The ﬁrstbest pay schedule y(ω), which together with w(ω) solves the max
imization problem (33)(34), can be written as y(w(ω), s).
Lemma 3 shows we can replace y(ω) by y(w(ω), s) in the maximization problem
(33)(34). Then, applying Lemma 1 to u + λv implies that the ﬁrstbest contracting
problem is equivalent to
max
f
ws
(w)∈A
w
, y(w,s)
ds f
s
(s)
u(α(w, s) −y(w, s))f
ws
(w) dw
subject to
ds f
s
(s)
v(y(w, s))f
ws
(w) dw ≥ v
0
.
In addition, and for the sake of comparison with the case of the second best, we use
y(w, s) = h(x) = v
−1
(x). Then the Lagrangian of the reformulated maximization
problem is as follows:
L(f
ws
, x, λ
w
, λ
v
, λ
f
) =
L
s
(f
ws
, x, λ
w
, λ
v
, λ
f
)f
s
(s) ds,
16
where
L
s
(f
ws
, x, λ
w
, λ
v
, λ
f
) =
u(α(w, s) −h(x))f
ws
(w) dw
−λ
w
¸
F
−1
ps
(1 −F
ws
(w))wf
ws
(w) dw −w
0
+λ
v
¸
xf
ws
(w) dw −v
0
+
λ
f
(w, s)f
ws
(w) dw.
Using the variational method that perturbs f
ws
by
f
η
f
(w, s) and x by
x
η
x
(w, s),
where
f
and
x
are two constants and
η
f
(w, s) dw = 0 and
η
x
(w, s)f
ws
(w) dw < ∞,
we immediately have the following.
Proposition 4 A pair (f
ws
, x(w, s)) is a ﬁrstbest solution to the principal’s problem
if and only if it satisﬁes the following ﬁrstorder conditions
u(α(w, s)−h(x(w, s)))+λ
v
x(w, s)+λ
f
(w, s)−λ
w
w
F
−1
ps
(1−F
ws
(t)) dt = C(s) (35)
and
[u
(α(w, s) −h(x))h
(x) −λ
v
] f
ws
(w) = 0 (36)
almost everywhere for any such that f
ws
() > 0, where C(s) is independent of w
and x.
Similar to the secondbest case, the ﬁrstorder condition (35) can be used to handle
corner solutions. However, the corner solutions are quite straightforward for the ﬁrst
best case, that is, replacing u + λ
v
x + λ
f
in equation (35) by the concaviﬁcation of
u +λ
v
x along the dimension w. Thus λ
f
for the ﬁrstbest case can be predetermined
hence the interior part of the solutions are solved by simpler conditions.
Corollary 1 If λ
f
(w, s) = 0 at (w, s), then the ﬁrstbest contracts are given by
y(w(p), s) = [v
]
−1
λ
w
p
λ
v
α
(w, s)
17
and the ﬁnal wealth is implicitly given by
α(w, s) = [u
]
−1
λ
w
p
α
(w, s)
+ [v
]
−1
λ
w
p
λ
v
α
(w, s)
,
where α
(w, s) is the ﬁrstorder derivative with respect to w, and λ
w
and λ
v
are de
termined by the budget and participation constraints.
If u(α(w, s) −h(x)) is a concave function of (w, x) for all s, then λ
f
(w, s) ≡ 0 for
all (w, s).
Corollary 1 shows that the ﬁrstbest contracts have closedform solution for many
types of utility functions, e.g., the class of power utilities. In addition, Corollary 1
also reveals another interesting implication of the model. The ﬁrstbest contracts do
not depend on any signals if the gross beneﬁt of the principal α does not depend on
a signal even they are deﬁned on a ﬁner partition of the state space than the state
price. To achieve the ﬁrstbest results, all it needs is the distribution of the state price
if it can be contracted upon. However, the secondbest contracts can be improved by
conditioning on some signals even though they may not be perfect substitutes for the
state price.
3.3 Information and Eﬃciency
From the formulations of the contracting problems, it is clear that if the signal s
represents a ﬁner partition on the state space Ω then the ﬁrstbest contracts are
achievable. That is the secondbest contracts are the same as the ﬁrstbest ones. A
formal statement of this observation is as follows.
Theorem 1 If f
ps
(p) is singular, then the secondbest contracts are the same as the
ﬁrstbest contracts.
An important and interesting question in portfolio delegation is: what state vari
ables can be contracted upon? In practice, one may expect that since the security
18
price (or returns) processes can be observed, they can thus be contracted upon. How
ever, casual observations tell us that practical pay schedules are hardly contracted
upon all the perceivable contingent price states. Enforceability, liquidity, and other
market imperfections prevent us from using all price information in the design of
compensation schemes. In addition, Theorem 1 shows that we do not need such full
price information to achieve the ﬁrstbest results. If there exists an index of market
portfolio, which is perfectly correlated with the state price, then the ﬁrstbest results
are always achievable by writing contracts based on this index. However, such an
index of the market portfolio may not exist or the market portfolio is not observable
in reality. In practice, many pay contracts use some passive indexes as a benchmark
in the design of compensation schemes because of high liquidity, easy enforcement,
and low contracting costs of these passive indexes. If these indexes are not perfect
substitutes for the state price itself, then how and in what degree are these imper
fect signals able to improve the secondbest results? To further explore this and
other contracting issues as well as to illustrate how the model can be applied, we will
go through a detailed example in a continuoustime setup, which is widely used in
modeling the dynamics of securities prices.
4 An Example in ContinuousTime
Our analysis in the previous sections can be carried over to a continuoustime model,
where passive indexes as contractible signals and manager’s dynamic portfolio selec
tion issues can be addressed explicitly. In this section we will not seek generality in
applying our approach, but rather we will develop a speciﬁc model to highlight some
important points our approach can address. Such a model is also more relevant in
reality. In our continuoustime model, the time horizon is [0, T], the principal (in
vestors or a fund company) hires a manager to manage her initial wealth w
0
at time 0
and the ﬁnal wealth under the manager’s management at time T, which is random, is
denoted by w = W
T
. In practice, a fund under management normally has an external
fund inﬂow or outﬂow in the process of portfolio selection. While introducing an
19
exogenous fund ﬂow causes no additional conceptual diﬃculty, we assume away the
external ﬂow issue for simplicity. In other words, throughout this section we assume
that the manager’s trading strategies are selfﬁnanced.
There are N+1 securities available in the market for the manager to trade. One
is a riskfree bond, and the others are N risky securities. We assume that the bond’s
price S
0
t
follows a deterministic process and has a constant short rate r, dS
0
= rS
0
dt.
For the N risky securities, their price process S = (S
1
, ..., S
N
)
is assumed to follow
a multidimensional geometric Brownian motion
dS
S
= µdt + σdB, S(0) > 0, (37)
where
dS
S
, µ, and B are the transpose of
dS
1
S
1
, ...,
dS
N
S
N
, (µ
1
, ..., µ
N
) and (B
1
, ..., B
d
)
respectively, and σ is a N × d matrix. Note that B is a standard Brownian motion
in R
d
on a probability space (Ω, F, P) , with the standard ﬁltration denoted by F
t
.
We will further assume that the ﬁnancial market is complete, thus set d = N without
loss of generality. Under such a condition, σ is a N ×N matrix with a full rank.
A manager’s trading strategy is an admissible process π =
π
1
, ..., π
N
that is
progressively measurable with respect to the ﬁltration F
t
and satisﬁes
E
T
0
π
2
dt
< ∞
almost surely, where π
i
is the fraction of total wealth held in the ith risky security.
Given a trading strategy, then the corresponding total wealth process as follows
dW
t
W
t
=
r + π
(µ −r1)
dt + π
σ dB; W
0
= w
0
, (38)
where 1 is a vector with all elements 1. Note that the manager’s trading strategy π
cannot be observed by the principal, thus cannot be contracted upon.
Given our model setup, the density process ξ
t
at time T for the equivalent mar
tingale measure is given by
ξ
T
= exp
−
1
2
θ
2
T −θ
B
T
, (39)
20
where θ = σ
−1
(µ −r1). The associated (deﬂated) stateprice p at time T is p =
e
−rT
ξ
T
, and the corresponding state price density function f
p
(p) can be written as
f
p
(p) =
1
√
2πσ
p
p
exp
¸
−
1
2
ln p −µ
p
σ
p
2
¸
, (40)
where µ
p
= −
r +
1
2
θ
2
T and σ
p
= θ
√
T.
Similar to the static case in the previous section, the principal designs compen
sation schemes y (w, s) based on the ﬁnal wealth and security price information s,
where s could be the information generated by a set of security (or portfolio) price
processes, and the principal and the fund manager maximize their expected utility
functions based on the ﬁnal wealth at time T and the relevant information s. Ideally,
all security price processes, together with the wealth process, can be available for
contracting. In practice, however, it is very costly, if not impossible, to contract upon
all security prices due to liquidity problems or other market imperfections. Therefore,
practitioners typically design their contract based upon the ﬁnal wealth and a set of
actively traded passive index funds (or portfolios of securities).
4.1 Stock Index
A passive index is formed by a subset of the N stocks. A trading strategy π
s
such
that
¸
π
i
s
= 1 forms an index whose return follows a geometric Brownian motion by
equation (38). The gross return for this index over a period [0, T] is given by
R
s
= exp
¸
π
s
µ −
1
2
σ
π
s
2
T + π
s
σB
T
,
which follows a normal distribution with a mean of µ
s
=
π
s
µ −
1
2
σ
π
s
2
T and a
variance of σ
s
= σ
π
s
√
T. Since p and s is joint normal, the conditional distribution
of state price p on the signal s = ln R
s
is
f
ps
(p) =
1
2π(1 −ρ
2
)σ
p
p
exp
¸
−
1
2(1 −ρ
2
)σ
2
p
ln p −µ
p
−ρ
σ
p
σ
s
[s −µ
s
]
2
¸
, (41)
where ρ = −
π
s
σθ
σ
p
σ
s
is the correlation between p and s. Thus a contract can use the
return of such an index to improve the eﬃciency.
21
A special case in which an index is perfectly correlated with the state price oﬀers
an ideal solution to the ineﬃciency of the secondbest contracts if such an index exists
and is observable. From the discussion above, we know that the trading strategy for
such an index is γ
m
σ
π
s
= θ, where γ
m
is a constant scaler. This shows the trading
strategy for this index is
π
s
=
σσ
−1
(µ −r1)
1
[σσ
]
−1
(µ −r1)
. (42)
Note that π
s
is a constant, preferencefree, and is determined by the price parameters
only.
11
This index is also known as the market portfolio in the asset pricing literature.
The relation between the state price p and the return of the market portfolio is
R
s
= R
0
p
−
1
γ
m
, (43)
where
R
0
= exp
¸
π
s
µ −
r1
γ
m
−
1
2γ
m
1 +
1
γ
m
σ
2
p
T
and
γ
m
= 1
σσ
−1
(µ −r1) .
The parameter γ
m
can be interpreted as the relative risk aversion coeﬃcient of an
investor who optimally invests all wealth in the stocks.
4.2 Market Portfolio
As a benchmark, we ﬁrst study the contracting problem in the case in which there is
a market portfolio that is observable, and hence can be used in contracts. As shown
in Theorem 1 the secondbest contracts are the same as the ﬁrstbest ones for this
case, so, we only need to solve the ﬁrstbest contracts. We also assume that the gross
payoﬀs to the principal is:
α(w, s) = α
0
w + α
1
(w −w
0
R
s
e
µ
T
)
+
= w
0
[α
0
R + α
1
(R −R
s
e
µ
T
)
+
],
11
See, e.g., Merton (1971, 1973).
22
where R = W
T
/W
0
and R
s
is the gross return of the market portfolio,
12
given by
equation (43), and µ
is a constant. The optionlike pays capture some incentives or
the eﬀects of fund ﬂows.
Since the gross payoﬀ of the principal is convex, we have to concavify the welfare
function u + λ
v
v for each R
s
. This can be done by setting the following equations,
which are one of the direct implications of equation (35) in Proposition 4,
u
[α
(w
l
, s) −y
(w
l
, s)] + λ
v
v
y
(w
l
, s)
= u
[α
(w
h
, s) −y
(w
h
, s)] + λ
v
v
y
(w
h
, s) (44)
=
u(α(w
h
, s) −y(w
h
, s)) + λ
v
v(y(w
h
, s)) −u(α(w
l
, s) −y(w
l
, s)) −λ
v
v(y(w
l
, s))
w
h
−w
l
.
Here f
ws
(w) ≡ 0 on the interval (w
l
, w
h
). Due to the endogeneity of the multiplier
λ
v
and the pay schedule y, this concaviﬁcation cannot be done without solving the
contracting problem. Coupling these equations with the ﬁrstorder conditions in
Proposition 4 gives us the solution of the ﬁrstbest contracting problem.
Let us consider a speciﬁc example in which both of the principal and agent have
a power utility as
w
1−γ
1 −γ
.
Let γ
p
and γ
a
be the relative risk aversion coeﬃcient of the principal and the agent,
respectively. We also use a certain equivalent pay w
r
to express the reservation of the
agent, which is deﬁned as solving
w
1−γ
a
r
1 −γ
a
= v
0
. (45)
This seems to be a sensible way of deﬁning agents’ reservation because agents are
competing with pay levels rather than utility levels in the markets for money man
agers.
12
The ﬁrstbest contract for the case of an arbitrary benchmark portfolio is also straightforward
as given in Corollary 1.
23
Corollary 2 Suppose that both the principal and agent have power utility and the
market portfolio is observable. Then the optimal pay schedule is given by
y(p) =
λ
w
p
λ
v
α
0
−
1
γ
a
if p ≥ ¯ p
λ
w
p
λ
v
(α
0
+α
1
)
−
1
γ
a
if p < ¯ p
and the ﬁnal wealth is given by
w(p) =
1
α
0
¸
λ
w
p
α
0
−
1
γ
p
+
λ
w
p
λ
v
α
0
−
1
γ
a
if p ≥ ¯ p
1
α
0
+α
1
¸
λ
w
p
α
0
+α
1
−
1
γ
p
+ α
1
w
0
R
p
−
1
γ
m
+
λ
w
p
λ
v
(α
0
+α
1
)
−
1
γ
a
if p < ¯ p,
where R
= R
0
e
µ
T
and ¯ p, λ
w
, and λ
v
are determined by the system of equations:
¸
(α
0
+ α
1
)
1
γ
p
−1
−α
1
γ
p
−1
0
γ
p
1 −γ
p
λ
−
1
γ
p
w
¯ p
−
1
γ
p
+
γ
a
1 −γ
a
λ
w
λ
v
−
1
γ
a
¯ p
−
1
γ
a
¸
=
α
1
w
0
R
α
0
+ α
1
¯ p
−
1
γ
m
, (46)
e
−
1−γ
p
γ
p
“
µ
p
−
1−γ
p
2γ
p
σ
2
p
”
α
1
γ
p
−1
0
[1 −A(γ
p
)] + (α
0
+ α
1
)
1
γ
p
−1
A(γ
p
)
λ
−
1
γ
p
w
+e
−
1−γ
a
γ
a
(
µ
p
−
1−γ
a
2γ
a
σ
2
p
)
α
1
γ
a
−1
0
[1 −A(γ
a
)] + (α
0
+ α
1
)
1
γ
a
−1
A(γ
a
)
λ
w
λ
v
−
1
γ
a
+e
−
1−γ
m
γ
m
(
µ
p
−
1−γ
m
2γ
m
σ
2
p
)
α
1
w
0
R
α
0
+ α
1
A(γ
m
) = w
0
, (47)
and
e
−
1−γ
a
γ
a
(
µ
p
−
1−γ
a
2γ
a
σ
2
p
)
α
1
γ
a
−1
0
[1 −A(γ
a
)] + (α
0
+ α
1
)
1
γ
a
−1
A(γ
a
)
λ
w
λ
v
1−
1
γ
a
= (1 −γ
a
)v
0
, (48)
where
A(γ) = N
ln ¯ p −µ
p
σ
p
+
1 −γ
γ
σ
p
,
where N(·) is the cumulative distribution function of a standard normal random vari
able.
24
Under the ﬁrstbest contracts, both pay schedule and ﬁnal wealth are monotone
functions of state price. Hence there is a unique relation between pay schedule and
ﬁnal wealth. This is especially useful in comparisons between the ﬁrst and second
best contracts. Without confusion, we also call this relation the ﬁrstbest contracts.
The following graphs illustrate this relations for two numerical examples.
0
0.005
0.01
0.015
0.02
0.025
0.03
0.035
0.5 1 1.5 2 2.5
α(w, s) = 0.02 w + 0.05 (w  w
0
R
s
)
+
α(w, s) = 0.02 w
α(w, s) = w
Figure 1: Firstbest contracts against ﬁnal wealth with the same reservation. Both
ﬁnal wealth and pay schedules are normalized by the initial wealth. Preferences are
power utilities and the relative risk aversion coeﬃcients of the principal and agent
are γ
p
= 3 and γ
a
= 0.3, respectively. The parameters are: σ
p
= 0.5, µ
s
= 10%,
σ
s
= 30%, r = 5%. The gap in the graph represents the region of {wf
ws
(w) = 0}
caused by the covexity of α(w, s).
Figure 1 plots the ﬁrstbest contracts in the case in which the principal (a fund
company or an individual investor) is more risk averse than the agent. This plot
shows that the agent takes more risk by oﬀering a convex pay schedule. This is the
result of the optimal risk sharing between principal and agent. Intuitively, the ﬁrst
best pay schedule becomes concave if the agent is more risk averse than the principal
25
as illustrated in Figure 2.
0.002
0.003
0.004
0.005
0.006
0.007
0.008
0.009
0 1 2 3 4 5 6
α(w, s) = 0.02 w + 0.05 (w  w
0
R
s
)
+
α(w, s) = 0.02 w
α(w, s) = w
Figure 2: Firstbest contracts against ﬁnal wealth with the same reservation. Both
ﬁnal wealth and pay schedules are normalized by the initial wealth. Preferences are
power utilities and the relative risk aversion coeﬃcients of the principal and agent
are γ
p
= 0.3 and γ
a
= 3, respectively. The parameters are: σ
p
= 0.5, µ
s
= 10%,
σ
s
= 30%, r = 5%. The gap in the graph represents the region of {wf
ws
(w) = 0}
caused by the covexity of α(w, s).
Although there is no incentive concern in the ﬁrstbest contracts, the ﬁrstbest
pay schedule may be very sensitive to the performance of a delegated portfolio. Such
sensitivities are solely due to the optimal risk sharing and becomes a constant if both
principal and agent share the same preferences. If the ﬁrstbest model presented
here is a good approximation for some of the delegated portfolio management, e.g.,
existing a good proxy for the market portfolio, then diﬀerent pay contracts across fund
companies are simply the results of diﬀerent risk attitudes among fund companies and
managers.
26
4.3 Imperfect Signals
In practice, the market portfolio is not observable due to various reasons, hence an
index with a subset of stock is used in the contracting problem. In this case, we have
to seek the secondbest solutions. Due to the numerical complexity, we only consider
a simple case in which
α(w, s) = α
0
w.
By equation (41), we have
f
ps
(p)
f
ps
(p)
= −
1
(1 −ρ
2
)σ
2
p
p
ln p −ρ
σ
p
σ
s
s −µ
ps
, (49)
where s = ln R
s
and µ
ps
= µ
p
− ρ
σ
p
σ
s
µ
s
− (1 − ρ
2
)σ
2
p
is a constant. Substituting this
into the ODE (27) and using p = x
/λ yields, for each s,
¸
β −2u
h
−
u
[α
0
−h
x
] + (β −λ
v
)x
(1 −ρ
2
)σ
2
p
x
ln x
−ρ
σ
p
σ
s
s −µ
ps
−ln λ
x
= −u
[α
0
−h
x
]
2
+ u
h
[x
]
2
. (50)
Because the righthand side of the ODE is positive and x
≤ 0, the solution has to
satisfy the constraint
β −2u
h
−
u
[α
0
−h
x
] + (β −λ
v
)x
(1 −ρ
2
)σ
2
p
x
ln x
−ρ
σ
p
σ
s
s −µ
ps
−ln λ
< 0. (51)
The secondorder ODE (50) can be solved numerically by transforming it into a
system of ﬁrstorder ODEs given a set of boundary conditions. Because the ODE
contains parameters that are determined endogenously, it is not obvious to choose
starting values. However, the asymptotic behavior of the ODE can be obtained by
combining it with the diﬀerentialintegral equation (25).
Lemma 4 Given (λ, λ
w
, λ
v
). If x is a secondbest solution to the contracting problem,
then
u
[α
0
−h
x
] + (β −λ
v
) x
−→ 0
as w goes to ∞.
27
This lemma sets additional constraints on the feasible solutions to the ODE. Such
constraints make the searching a numerical solution much easier.
0
0.005
0.01
0.015
0.02
0.025
0.03
0.5 1 1.5 2 2.5 3
Firstbest
P = 1%
P = 99%
s = 50%
s = 38%
s = 26%
s = 14%
s = 02%
s = 10%
s = 22%
s = 34%
s = 46%
s = 58%
s = 70%
Figure 3: Optimal contracts against ﬁnal wealth. Both ﬁnal wealth and pay schedules
are normalized by the initial wealth. Label “s” represents the secondbest conditional
on returns of a benchmark portfolio and “P” represents the conditional cumulative
probability distributions of ﬁnal wealth. Preferences are power utilities and the rel
ative risk aversion coeﬃcients of the principal and agent are γ
p
= 3 and γ
a
= 0.3,
respectively. The gross beneﬁt of the principal α(w) = 0.02w. The parameters are:
σ
p
= 0.5, µ
s
= 10%, σ
s
= 30%, r = 5%, and ρ = 0.8.
We present two numerical examples in the following. In the ﬁrst example, the
principal is assumed to collect a 2% fee on the ﬁnal wealth from the fund investors.
The model parameters are stated in the ﬁgures captions. Figure 3 plots the optimal
contracts, both the ﬁrst and secondbest, against the ﬁnal wealth, where the second
best pay schedules are conditional on the returns of the benchmark index. In addition,
the cumulative distribution conditional on the benchmark returns for 1% and 99%
is also ploted in the graph. One of the striking features of the secondbest contracts
28
is the ﬂatness conditional on the benchmark returns within a reasonable range of
portfolio returns. This indicates managers will not get large rewards for dazzling
performance relative to the benchmark. However, they do get hefty rewards when
the returns of the benchmark are high even the return of the managed portfolio is
below the benchmark.
0.002
0.00205
0.0021
0.00215
0.0022
1 1.5 2 2.5 3 3.5
s = 9.94%
s = 10.06%
s = 10.18%
P = 1.00%
P = 99.00%
Figure 4: Secondbest contracts against ﬁnal wealth. Both ﬁnal wealth and pay
schedules are normalized by the initial wealth. Label “s” represents the secondbest
conditional on returns of a benchmark portfolio and “P” represents the conditional
cumulative probability distributions of ﬁnal wealth. Preferences are power utilities
and the relative risk aversion coeﬃcients of the principal and agent are γ
p
= 3 and
γ
a
= 0.3, respectively. The gross beneﬁt of the principal α(w) = 0.02w. The param
eters are: σ
p
= 0.5, µ
s
= 10%, σ
s
= 30%, r = 5%, and ρ = 0.8.
Another interesting feature to notice is the similarities between the contour curves
for ﬁxed conditional cumulative probabilities, e.g., the curve with P = 1% in Figure 3,
and the ﬁrstbest pay schedule. This illustrates the role of the benchmark in designing
the secondbest contracts. The benchmark makes the secondbest contracts more
29
ﬁrstbest like, and thses two kinds of contracts become exactly the same when the
return of benchmark is perfectly correlated with the state price. This is of course an
indication of eﬃciency improvement by incorporating the benchmark in designing the
secondbest contracts. Such eﬃciency gains are also evident by the clear separations
of the conditional pay schedules. The usefulness of the benchmark is determined by
the correlation between the benchmark and state price; the conditional pay schedules
get closer with a lower correlation.
Of course the ﬂatness of the secondbest contracts is only a relative term. For
example, the pay should converge to 0 with the gross return. The plots truncate the
pay schedule to illustrate its insensitivity to returns in a reasonable range. Figure 4
further illustrates the detailed secondbest contract conditional on particular levels of
the benchmark returns. It is obvious that the conditional pay schedules are concave
but the absolute variations are quite small. This is why they look very ﬂat in Figure
3.
Figures 5 and 6 replicate the previous two plots but with diﬀerent preferences and
gross beneﬁt of the principal (e.g., a wealthy individual investor). At this time, the
principal is less risk averse. Although, as indicated by Figures 1 and 2, the shapes
of the ﬁrstbest contracts are quite distinguished by the relative risk aversion be
tween the principal and agent, the conditional secondbest contracts are quite similar
in terms of ﬂatness and concavity, especially in the reasonable range of portfolio re
turns. All qualitative observations we have discussed for the previous case are exactly
applied here, too. The less sensitivity to the benchmark is due the less divergence of
preferences between the principal and agent.
There are two opposite forces working against each other in the secondbest con
tracting problem; one is the risksharing, the other is the similarity. The latter means
designing a pay schedule such that eﬀective preferences for the agent, v(y), is similar
to the principal’s. As shown in the case of ﬁrstbest contracting problem, optimal
risksharing is to let the less riskaverse party take more risk. However, the similarity
condition requires that the less riskaverse party taking more risk, hence the eﬀective
preferences after splitting the gross returns are similar. These two opposite condi
30
0.0005
0.0006
0.0007
0.0008
0.0009
0.001
0.0011
0.0012
0 0.5 1 1.5 2 2.5 3 3.5
s = 70%
s = 60%
s = 50%
s = 40%
s = 30%
s = 20%
s = 10%
s = 00%
s = 10%
s = 20%
s = 30%
s = 40%
s = 50%
Firstbest
P = 01%
P = 99%
Figure 5: Optimal contracts against ﬁnal wealth. Both ﬁnal wealth and pay schedules
are normalized by the initial wealth. Label “s” represents the secondbest conditional
on returns of a benchmark portfolio and “P” represents the conditional cumulative
probability distributions of ﬁnal wealth. Preferences are power utilities and the rel
ative risk aversion coeﬃcients of the principal and agent are γ
p
= 1.5 and γ
a
= 3,
respectively. The gross beneﬁt of the principal α(w) = w. The parameters are:
σ
p
= 0.5, µ
s
= 10%, σ
s
= 30%, r = 5%, and ρ = 0.8.
tions make the secondbest contracts ﬂat, especially in comparison to the ﬁrstbest
contracts. This qualitative feature of the secondbest contracts also holds for the ones
without any signals. As shown in Li and Zhou (2005), the ﬂatness is also prevalent in
the case in which the state price follows a uniform distribution, and it also depends
on the level of reservation, which aﬀects the relative strength between risksharing
and preference similarity.
Although the secondbest contracts are concave in the reasonable range of portfolio
returns for the two examples, we cannot conclude that they are always concave,
especially for extreme returns. Again, as shown in Li and Zhou (2005), the second
31
0.00079237
0.00079238
0.00079239
0.0007924
0.00079241
0.00079242
0 1 2 3 4 5 6 7 8
s = 10%
P = 1%
P = 99%
Figure 6: Secondbest contracts against ﬁnal wealth. Both ﬁnal wealth and pay
schedules are normalized by the initial wealth. Label “s” represents the secondbest
conditional on returns of a benchmark portfolio and “P” represents the conditional
cumulative probability distributions of ﬁnal wealth. Preferences are power utilities
and the relative risk coeﬃcients of the principal and agent are γ
p
= 1.5 and γ
a
= 3,
respectively. The gross beneﬁt of the principal α(w) = w. The parameters are:
σ
p
= 0.5, µ
s
= 10%, σ
s
= 30%, r = 5%, and ρ = 0.8.
best contracts can be a combination of locally concave and convex curves. A more
detailed study of the secondbest contracts is interesting. However, such an inquiry,
which calls for a rigorous analytical treatment of the ODE and a tailormade numerical
method, is outside the scope of this paper.
As a ﬁnal note, we notice that the shape of the secondbest contract in the clas
sical principalagent models with moral hazard is steeper than that of the ﬁrstbest
contract. This is consistent with our intuition, since the principal needs to motivate
the agent to exert a high eﬀort. In contrast, the shape of the secondbest contract in
our context is ﬂatter than that of the ﬁrstbest contract, as the investor does not have
32
to motivate a high manager’s eﬀort. This diﬀerent prediction of the optimal contract
shows the key diﬀerence between the model with eﬀort and the model with choice.
5 Conclusion
The stock indexes are created for many diﬀerent purposes. In this paper we show
that one of their side eﬀects is socially valuable, that is, they can help to reduce, or
eliminate when properly constructed, agency costs when the fund manger’s portfolio
choice cannot be contracted upon. The condition for a stock index to achieve the
ﬁrstbest risk sharing is strikingly simple: it only needs to be a market portfolio,
which is by deﬁnition perfectly correlated with the state price. In this situation, the
fund’s total return plus the benchmark return can implement the ﬁrstbest contract.
In general, however, the market portfolio may not be observable. Then, a close
substitute, e.g., a stock index, can be used in the contract design. In this case the
magnitude of eﬃciency improvement depends on how close the stock index is to the
market portfolio.
The next natural step to enrich our model would be to introduce the fund man
ager’s private information or other information structures into the analysis. Doing so
would shed light on the nature of contracts for the managers of “actively” managed
funds, which would be a complement to what we have done in this paper. This is
a largely unexplored area. As mentioned earlier, Stoughton (1993), and Admati and
Pﬂeiderer (1997) point out some problems of the popular linear contract and bench
marks in the presence of private information. However, their conclusion is based on
a given class of compensation schemes. The true role of benchmarks in the design of
optimal compensation schemes in this rich environment is still not well understood,
and a lot of work is left to be done along this line.
33
Appendix: Proofs
Proof of Lemma 1
See Lemma 1 in Li and Zhou (2005).
Proof of Lemma 2
We need the following result ﬁrst to proceed the proof. This result is also used in
solving the contracting problems later.
Lemma A.1 For any given distribution function f
ws
, let E
[pw] be the present value
of the wealth under a perturbed density function f
ws
= f
ws
+η, where is a constant
and η satisﬁes
η(t, s) dt = 0. Then,
dE
[pw]
d
=
ds f
s
(s)
∞
0
η(w, s)
¸
w
F
−1
ps
(1 −F
ws
(t)) dt
dw
and
d
2
E
[pw]
d
2
=
ds f
s
(s)
∞
0
1
f
ps
(F
−1
ps
(1 −F
ws
(w)))
w
0
η(t, s) dt
2
dw,
where is an arbitrary number such that f
ws
() > 0 or F
−1
ps
(1 −F
ws
()) is ﬁnite.
Proof. Perturb the density function f
ws
by η(w, s), where is a small constant and
η(w, s) is an arbitrary piece wise smooth function that satisﬁes
∞
0
η(w, s) dw = 0.
Let F
ws
denote the cumulative distribution function conditional on the signal s. Note
that
1 −F
ws
(w) = 1 −
w
0
[f
ws
(t) + η(t, s)] dt =
∞
w
[f
ws
(t) + η(t, s)] dt.
Let
E
s,
[w] =
∞
0
f
ws
(w)F
−1
ps
(1 −F
ws
(w))wdw.
34
Then, the ﬁrst derivative of the perturbed expected wealth is
dE
s,
[w]
d
=
∞
0
η(w, s)wF
−1
ps
(1 −F
ws
(w)) dw −
∞
0
wf
ws
(w)
f
ps
w
0
η(t, s)dt dw.
Applying the integration by parts to the second integral of the right hand side yields
∞
0
wf
ws
(w)
f
ps
w
0
η(t)dt dw
=
w
tf
ws
(t)
f
p
dt
w
0
η(t) dt
∞
0
−
∞
0
η(w)
w
tf
ws
(t)
f
ps
dt dw
=
∞
0
η(w)
¸
wF
−1
ps
(1 −F
ws
(w)) −F
−1
ps
(1 −F
ws
())
−
w
F
−1
ps
(1 −F
ws
(t)) dt
dw,
where is a positive number. This shows that
dE
s,
[w]
d
=
∞
0
η(w)
¸
w
F
−1
ps
(1 −F
ws
(t)) dt
dw.
Then, taking derivatives to the above equation again and integrating by parts shows
that
d
2
E
s,
[w]
d
2
=
∞
0
η(w, s)
¸
−
w
1
f
ps
t
0
η(a, s) da dt −
f
ps
0
η(a, s) da
dw
=
∞
0
1
f
ps
(F
−1
ps
(1 −F
ws
(w)))
w
0
η(t, s) dt
2
dw,
where the term with equals zero. Finally, the relation between E
and E
s,
leads to
the lemma.
Let x(w, s) = v(y(w, s)). To maximize the Lagrangian given by (15) is to maximize
the following:
V
s
=
∞
0
x(w, s)f
ws
(w) dw −λ
∞
0
f
ws
(w)[F
−1
ps
(1 −F
ws
(w))]wdw −w
0
+
∞
0
λ
f
(w, s)f
ws
(w) dw,
where λ is a positive constant and λ
f
(w, s) is a nonnegative function, which equals
zero when f
ws
> 0 and is nonnegative when f
ws
= 0. Then, following the proce
dure as described in the proof of Lemma 1, let f
ws
(w) = f
ws
(w) + η(w, s), where
35
∞
0
η(w, s) dw = 0 and f
ws
is the optimal solution. Then, deﬁne the perturbed La
grangian as
V
s,
=
∞
0
[x(w, s) + λ
f
(w, s)] f
ws
(w) dw
−λ
∞
0
f
ws
(w)[F
−1
ps
(1 −F
ws
(w))]wdw
.
Using Lemma 1, the ﬁrst two derivatives of the Lagrangian with respect to are
dV
s,
d
=
∞
0
η(w, s)
¸
x(w, s) + λ
f
(w, s)
− λ
w
F
−1
ps
(1 −F
ws
(t)) dt + F
−1
ps
(1 −F
ws
())
dw,
and
d
2
V
s,
d
2
= −λ
∞
0
1
f
ps
(F
−1
ps
(1 −F
ws
(t)))
w
0
η(t, s) dt
2
dw < 0.
This shows that the Lagrangian V
s
always has an interior maximum and the ﬁrst
order condition
dV
s,
d

=0
= 0 is both suﬃcient and necessary when we restrict f
ws
≥ 0.
Yet this is true if and only if there exists a function c(s) which does not depend on
w, such that
x(w, s) −λ
w
F
−1
ps
(1 −F
ws
(t)) dt −λF
−1
ps
(1 −F
ws
()) + λ
f
(w, s) ≡ c(s) (52)
holds almost everywhere. As x is bounded above by v(α(w, s)), there exists a function
F
ws
or f
ws
such that equation (52) holds.
This equality and Lemma 1 imply that
x(, s) −λF
−1
p
(1 −F
w
()) = c(s)
for all ∈ {t∞ > f
ws
(t) > 0}.
Let λ
(s) = x(, s) and deﬁne
˜ x(w, s) = λ
w
F
−1
ps
(1 −F
ws
(t)) dt + λ
(s).
As x(w, s) ≤ ˜ x(w, s) and ˜ x(w, s) is nondecreasing and concave, ˜ x(w, s) is the smallest
concaviﬁcation of x(w, s) for each s. Otherwise, it contradicts the ﬁrstorder condi
tion.
36
Proof of Proposition 1
The ﬁrstorder derivatives of U with respect to λ and λ
are straightforward by noting
that
x(w, s) = λ
w
F
−1
ps
(1 −F
ws
(t)) dt + λ
(s).
Then the second order derivatives are given by
∂
2
U
∂λ
2
= −
1
λ
2
ds f
s
(s)
∞
0
f
ws
(w)[x(w, s) −λ
(s)]
2
∂[u
h
]
∂x
dw < 0;
∂
2
U
∂λdλ
(s)
= −
1
λ
ds f
s
(s)
∞
0
f
ws
(w)[x(w, s) −λ
(s)]
∂[u
h
]
∂x
dw;
∂
2
U
∂λ
2
(s)
= −
ds f
s
(s)
∞
0
f
ws
(w)
∂[u
h
]
∂x
dw < 0,
where the negativeness of the second derivatives is due to the fact that
∂[u
h
]
∂x
= −u
[h
]
2
+ u
h
> 0,
because both u and v are concave functions. A direct calculation shows
∂
2
U
∂λ
2
∂
2
U
∂λ
2
−
¸
∂
2
U
∂λ∂λ
(s)
2
> 0.
Since this holds for any (λ, λ
(s)), the solution to the ﬁrstorder condition maximizes
the objective globally and is unique.
Proof of Proposition 2
Let U
s,
denote the perturbed U
s
, that is
U
s,
=
∞
0
[u + λ
v
x
+ λ
f
(w)]f
ws
dw −λ
w
E
s,
[pw] + λ
w
w
0
−λ
v
v
0
.
Then the ﬁrstorder derivative of U
is
dU
s,
d
=
∞
0
η(w, s)[u + λ
v
x
+ λ
f
(w)] dw
+
∞
0
f
ws
d[u + λ
v
x
]
d
dw −λ
w
dE
s,
[pw]
d
. (53)
37
First note that, using (18) or Lemma 2, we have
dx
(w)
d
= −λ
w
1
f
ps
t
0
η(a, s) da dt.
Then,
∞
0
f
ws
(w)
d[u + λ
v
x
]
d
dw = −
∞
0
[u
h
−λ
v
]f
ws
dx
(w)
d
dw
= λ
∞
0
[u
h
−λ
v
]f
ws
(w)
¸
w
1
f
ps
t
0
η(a, s) da dt
dw,
where we use the fact that the derivatives of λ
and λ
do not depend on w. Note that
the last two terms are equal to zero due to the ﬁrstorder conditions in Proposition
1. Therefore, integration by parts shows
∞
0
f
ws
(w)
d[u + λ
v
x
]
d
dw
= λ
∞
0
[u
h
−λ
v
]f
ws
(w)
¸
w
1
f
ps
t
0
η(a, s) da dt
dw
= λ
w
0
[u
h
−λ
v
]f
ws
(t) dt
w
1
f
ps
t
0
η(a, s) da dt
∞
0
−λ
∞
0
1
f
ps
w
0
η(t, s) dt
¸
w
0
[u
h
−λ
v
]f
ws
dt
dw
= λ
∞
0
η(w, s)
w
0
1
f
ps
¸
t
0
[u
h
−λ
v
]f
ws
da dt
dw,
where we have use the ﬁrstorder condition for λ
, equation (23). Using this equation
and Lemma 1, the ﬁrst derivative of U
with respect to is:
dU
s,
d
=
∞
0
η(w, s)
¸
u + λ
v
x
+ λ
f
+ λ
w
0
1
f
ps
t
0
[u
h
−λ
v
]f
ws
da dt
dw
−λ
w
∞
0
η(w, s)
¸
w
F
−1
ps
(1 −F
ws
(t)) dt
dw, (54)
38
where we have used Lemma 1. However, when = 0, we have x
= x and
dU
s,
d
=0
=
∞
0
η(w, s)
¸
u + λ
v
x + λ
f
+ λ
w
1
f
ps
t
0
[u
h
−λ
v
]f
ws
da dt
dw
−λ
w
∞
0
η(w, s)
¸
w
F
−1
ps
(1 −F
ws
(t)) dt
dw
=
∞
0
η(w, s)
¸
u + λ
v
x + λ
f
+
¸
λ
w
1
f
ps
t
0
[u
h
−λ
v
]f
ws
da dt −
λ
w
λ
x +
λ
w
λ
λ
dw = 0,
where the second last equality is obtained by using the constraints (18) or Lemma 2.
The above integral equals zero for any arbitrary η such that
∞
0
η(w, s) dw = 0
if and only if there exists a c(s) that is independent of w such that
u(α(w, s) −h(x(w, s))) + λ
v
x(w, s) −
λ
w
λ
x(w, s) + λ
f
(w, s)
+λ
w
1
f
ps
t
0
[u
h
−λ
v
]f
ws
(a) da dt = c(s) (55)
holds almost everywhere, where we ignore the constant terms. Speciﬁcally, we have
u(α(w, s) −h(x(w, s))) +
¸
λ
v
−
λ
w
λ
x(w, s)
+λ
w
1
f
ps
t
0
[u
h
−λ
v
]f
ws
(a) da dt = c(s)
when f
ws
(w) > 0.
Proof of Proposition 3
The derivation of the secondorder ODE is straightforward. See Li and Zhou (2005)
for the other results.
39
Proof of Lemma 3
Let F(w, ys) is the joint cumulative distribution function for given w(ω) ∈ A and
y(ω) conditional on the signal s, we then have
Ω
u(α(w(ω), s) −y(ω)) P(dω)
=
ds f
s
(s)
Ω
u(α(w(ω), s) −y(ω)) P(dωs)
=
ds f
s
(s)
u(α(w, s) −y) dF(w, ys)
=
ds f
s
(s)
dF
ws
(w)
u(α(w, s) −y) dF(w, ys, w)
≤
ds f
s
(s)
u(α(w, s)) −E[ys, w]) dF
ws
(w).
The last inequality is due to Jensen’s inequality and becomes equality if
y(ω) = y(w, s) for all ω ∈ {ω
(w(ω
) = w, s(ω
) = s}.
This means the optimal pay takes the form of y(w, s).
Proof of Proposition 4
Because x or (y(w)) is a free choice function, the maximization problem is quite
straightforward. It is similar to the case of agent’s problem for f
w
. The second order
is automatically satisﬁed by the budget constraint. And for the case of x, the second
order is due to that fact that u(α(w) −h(x)) is a concave function of x for any ﬁxed
w. We skip the details of the calculations.
Proof of Corollary 1
If λ
f
(w, s) = 0, f
ws
> 0. Then the two ﬁrstorder conditions in Proposition 4 become
u
α
= λ
w
p and u
= λ
v
v
. (56)
40
Then it is straightforward to check that these two equations imply the pay schedule
and the ﬁnal wealth in the corollary.
Having recognized that u + λ
v
x is concave in w if the condition is satisﬁed, the
second part follows immediately.
Proof of Theorem 1
It is trivial to examine the contracting problems or the ﬁrstorder conditions. If f
ps
is singular at s, then f
ws
(w) is also singular. Therefore, the ﬁrstorder conditions
(22) and (23) hold only if u
h
= λ
v
, then the third ﬁrstorder condition (24) becomes
equation (35) in light of equation (18).
Proof of Corollary 2
By Proposition 4, for any w / ∈ (w
l
, w
h
), where w
l
and w
h
satisfy equations (44), we
have u
α
= λ
w
p and u
= λ
v
v
. Substituting these equation into equations (16) leads
to
u(α(w
h
, s) −y(w
h
, s)) + λ
v
v(y(w
h
, s)) −u(α(w
l
, s) −y(w
l
, s)) −λ
v
v(y(w
l
, s))
w
h
−w
l
= λ
w
p, (57)
where s = R
s
is as deﬁned by equation (43). Also, by Corollary 1, we have the pay
schedule as given by
y(w(p), s(p)) =
λ
w
p
λ
v
α
0
−
1
γ
a
if w ≤ w
l
λ
w
p
λ
v
(α
0
+α
1
)
−
1
γ
a
if w ≥ w
h
and the ﬁnal wealth is given by
w(p) =
1
α
0
¸
λ
w
p
α
0
−
1
γ
p
+
λ
w
p
λ
v
α
0
−
1
γ
a
if w ≤ w
l
1
α
0
+α
1
¸
λ
w
p
α
0
+α
1
−
1
γ
p
+ α
1
w
0
R
p
−
1
γ
m
+
λ
w
p
λ
v
(α
0
+α
1
)
−
1
γ
a
if w ≥ w
h
.
41
Then, substituting these into (57) yields equation (46).
Given ¯ p, the pay schedule and ﬁnal wealth can be rewritten as in the the theorem.
Then, the budget constraint is
¯ p
0
w(p)pf
p
(p) dp +
∞
¯ p
w(p)pf
p
(p) dp = w
0
.
Using the identities, for any γ,
¯ p
0
p
−γ
f
p
(p) dp =
1
√
2πσ
p
ln ¯ p
−∞
e
−γx
e
−
1
2σ
2
p
(x−µ
p
)
2
dx
= exp
¸
−γ
µ
p
−
γσ
2
p
2
N
ln ¯ p −µ
p
+ γσ
2
p
σ
p
,
and
∞
¯ p
p
−γ
f
p
(p) dp = exp
¸
−γ
µ
p
−
γσ
2
p
2
¸
1 −N
ln ¯ p −µ
p
+ γσ
2
p
σ
p
gives us equation (47). Similarly, equation (48) is also obtained from the participation
constraint.
Proof of Lemma 4
Since both f
ps
and
w
0
[u
h
−λ
v
]f
ws
(t) dt converge to 0 as w goes to ∞, L’Hopital’s
rule implies
λ
f
ps
(p)
w
0
[u
h
−λ
v
]f
ws
(t) dt → −[u
h
−λ
v
]
λf
ps
(p)
f
ps
(p)
as w goes to ∞. Then, equation (25) shows
u
[α
0
−h
x
] + (β −λ
v
)x
→ [u
h
−λ
v
]
λf
ps
(p)
f
ps
(p)
.
Suppose this converges to a constant b. That is
u
[α
0
−h
x
] + (β −λ
v
)x
→ [u
h
−λ
v
]
λf
ps
(p)
f
ps
(p)
→ b. (58)
As w goes to ∞, x
= λp converges to 0 and
λf
ps
(p)
f
ps
(p)
converges to 0. In this case, at
best, u
h
∼
1
p
by equation (58) and
f
ps
(p)
f
ps
(p)
∼ −
p
ln p
, hence b has to equal 0.
42
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1
Introduction
The agency relationship arising in portfolio delegation and the resulting contracting problems are quite diﬀerent from those studied by the classical principalagent theory. First, the fund manager’s action space may include both eﬀorts on information collection and/or production and portfolio choices.1 As Diamond (1998) has noted in the context of the managerial compensation design, “Managers are called on to make choices as well as to make eﬀorts.” This is especially relevant for delegated portfolio management, in which the freedom of choices for the fund managers is much larger than that faced by a ﬁrm manager. Thus the choice aspect is as important as, if not more important than, the eﬀort dimension in the design of incentive fees in the investment fund industry. Second, the wealth process of a managed portfolio has to be endogenously determined through a well deﬁned trading strategy that satisﬁes budget constraints. Thus one cannot arbitrarily assume an exogenous relation between the actions and payoﬀs in portfolio delegation as a typical principalagent model does.2 These issues make the standard principalagent models diﬃcult or impossible to apply to the delegated portfolio management. Li and Zhou (2005), which characterizes the secondbest contracts that can be written only on the ﬁnal wealth or return of portfolios, is one of the ﬁrst attempts to move along this line. Built on Li and Zhou (2005), this paper further investigates the contracting problems in portfolio delegation with imperfect information. In particular, this research studies the role of stock indexes in the design of incentive fees in the investment fund industry. The model goes as follows. An investor, or a fund company, hires a fund manager to
1
The action space in the terms of portfolio choice can be very rich, e.g., in a continuoustime
setting. This richness of the agent’s action space has important implications on the structure of the optimal compensation schemes, see, for instance, Diamond (1998) and Mirrlees and Zhou (2005a, 2005b). 2 This does cause some additional technical problems that are absent in the classical principalagent model. This can be seen clearly from a model in a continuoustime setting, where, because of the budget constraint, the drift rate and the diﬀusion rate of the underlying wealth process cannot be controlled independently.
1
Electronic copy available at: http://ssrn.com/abstract=951707
manage her portfolio. The fund manager has no superior security selection skill3 in the sense that she has no private information compared to other fund managers in the market. We assume that the investor and fund manager share the same information or belief about the security markets at aggregate level, which can be summarized by assuming that both the investor and fund manager agree on the distribution of the price density function in the case of complete markets. However, at the micro level the fund manager does have better information than the investor about the risk characteristics of individual securities, which partially justiﬁes the necessity of portfolio delegation.4 Given this, our model addresses the contracting problems in a situation in which the fund manager does not have superior security selection skills (compared to other fund managers, of course) and her portfolio choice cannot be contracted upon. As a result, in designing incentive fees, the investor must rely on other variables, say stock indexes, to motivate the fund manager to make the right choice. We show that the ﬁrstbest results are always achievable if there is a market portfolio, which is, by deﬁnition, perfectly correlated with the underlying state price. Hence the role of the market portfolio in portfolio delegation is to recoup the eﬃciency loss due to the diﬀerent preferences between the investor and her fund manager. However, the market portfolio may not be observable hence cannot be contracted upon in reality, thus at best some imperfect observables, e.g., a stock index, can be used in the design of the pay schemes for fund managers. In this case, the eﬃciency loss of the secondbest contracts cannot be eliminated completely and the improvement of eﬃciency depends on how well the index correlates with the market portfolio or state price. We characterize the secondbest contracts with imperfect information under rather general conditions by an integral equation, which can be solved by piecewise ordinary diﬀerential equations (ODEs). Overall, our results shed light on
3
One of the reasons why a manager who possesses no superior skill is needed is the opportunity
costs for investors to constantly monitor the markets and trade in a continuoustime setting, see Mamaysky and Spiegel (2002) for more elaborations on this. 4 It is much less costly to collect market data on information at aggregate level than at micro level. In fact, as shown in this paper, all investors need to achieve the ﬁrstbest results is the market portfolio, if it is observable hence can be contracted upon.
2
and identify another role of stock indexes in the compensation of fund managers: it is used to recoup or reduce the eﬃciency loss of the secondbest contracts. This function of stock indexes played in fund managers’ compensations has been largely ignored in the literature. There are several important aspects that justify our model’s assumptions and conﬁrm their empirical relevance. First, there is extensive empirical evidence showing that, historically, the majority of fund managers fail to beat the market, even if many of them claim to be “active” fund managers. Thus, the assumption that the fund manager has no superior security selection skills has some empirical relevance in practice. Second, in reality, the structure of a fund manager’s compensation mainly depends on the past performance of the fund under management, on the fund’s total return relative to a prespeciﬁed benchmark, and on bonuses that are related to the proﬁtability of the ﬁrm that employs her (see, e.g., Chevalier and Ellison (1997) and Farnsworth and Taylor (2006)). While investors may place some restrictions on the fund manager’s portfolio choice, the fund manager has large freedom in trading assets in the markets and her incentive fees are seldom based on trading strategies directly. As a result, it is reasonable to treat the fund manager’s portfolio choice as a moral hazard variable, and to treat the conﬂicts of interest arising from the diﬀerent preferences between the investor and fund manager as a fundamental issue in the fund management industry. Third, although our model only deals with a simple agency relationship, that is, an investor versus a fund manager, our analysis has general implications to the situation where investors (or fund companies) hire many managers simultaneously.5 For example, the case of multiple fund managers can be made precise when investors’ utility is exponential and the asset classes managed by diﬀerent fund managers are relatively independent. Finally, our model conﬁrms the popular view held by practitioners that the use of benchmarks can be valuable,
5
In reality, the agency relationship is multilayer and complex. In general, investors (or fund
companies) allocate their capital (usually under the recommendation of agents) among many diﬀerent fund managers. However, the simple onetoone agency relationship considered in our model will not disappear, and investors (or fund companies) still have to face the individual fund manger’s incentive problem after the asset allocation decision has been made.
3
the stock indexes are valuable because they can be used to recoup or reduce the eﬃciency loss caused by the fund manager’s portfolio choice.but may be for a diﬀerent reason. we believe that the problem arising from the conﬂicts of interest due to the diﬀerent preferences between the investors and fund managers is among the most fundamental ones in the fund management industry. and thus can be used to align the interest of the fund manager with that of the investors to achieve optimal or near optimal risksharing. Similar to Li and Zhou (2005). As a result. We show that. Interestingly. As a result. some benchmarks already available in the markets exhibit some required features of the theoretically constructed market index. the major objective of which is to balance the portfolio’s risk and return that align with investors’ preferences and the managers of which need a right incentive to do so. the ﬁrst. the ﬁrstbest risk sharing can be achieved if and only if the stock index is perfectly correlated with the state price. our model has set up a foundation upon which further moral hazard variables can be introduced to enrich the model. our model is mostly relevant to a wide range of “passively” managed funds. In case the stock index is imperfectly constructed or a market index is impossible to construct. On the technical side. an incentive fee based on ﬁnal wealth alone is suﬃcient to achieve the ﬁrstbest risk sharing (see Li and Zhou (2005)). Overall. In our context. numerical calculation shows that the eﬃciency loss is small if the market index is highly correlated to the price density function. and not to induce the fund manager’s eﬀorts in collecting information. when the investor and fund manager have “similar” preferences. for a given stock index. In particular. 4 . we follow the method developed by Li and Zhou (2005) to solve the optimal contract with imperfect information.and secondbest contracts can be fully analyzed and compared. As a direct application. Our results indicate that a properly constructed stock index that is independent of preferences can solve or at least mitigate these conﬂicts of interest. we show that the problem of ﬁnding the optimal contract can be converted into the one that solves a nonlinear secondorder ordinary diﬀerential equation (ODE). It has to be fully addressed in the ﬁrst place before a fullﬂedged theory of portfolio delegation can be developed.
All proofs are provided in the appendix. and show that in general the use of benchmarks will not induce the fund manager to exert high eﬀorts in collecting information. they mainly focus on the the ﬁrstbest cases and do not characterize the secondbest contracts when the market portfolio is unobservable and hence cannot be contracted upon. OuYang (2003) and Dybvig. Pavlova. Farnsworth. The relation between the eﬃciency and the quality of information is also discussed in this section.and ﬁrstbest contracts conditional on some signals are characterized in Section 3. The next section studies the contracting problem with imperfect information in an abstract setting. Let (Ω. In contrast. we assume that there exists a rich set of ﬁnancial securities such that the ﬁnancial 5 . P ) be the space of states endowed with a probability measure and ω ∈ Ω be a state. The portfolio return is realized over a continuum of states in a single period. The second. Kraft and Korn (2004) also consider the role of the market portfolio played in the fund managers’ compensations. 2 The Basic Framework Consider a setting in which an investor or a fund company (the principal) wishes to hire a fund manager (the agent) to manage her portfolio. Stoughton (1993) and Admati and Pﬂeiderer (1997) study the adverse consequences of benchmarking in the presence of private information for a given class of compensation schemes. especially the secondbest. Most of them focus on the eﬀects of benchmarking on the fund manager’s trading strategy for a given class of compensation schemes (see Roll (1992) and Basak. F. and Carpenter (2004) treat the compensation scheme with benchmarks endogenously but focus on speciﬁc utilities. in which some features and implications of the optimal. contracts are further studied. The paper is organized as follows. As a start. and the predictions are mixed. we solve the optimal compensation scheme with imperfect information and general preferences in the secondbest world. However. and Shapiro (2003) and the reference therein).There are a number of papers that study the role of benchmarking in diﬀerent contexts. Section 4 oﬀers a detailed example in a continuoustime setting. Section 5 concludes the paper.
∞). possibly vector valued. our model is a typical principalagent problem. the net beneﬁt for the principal is assumed to be α(w. or. if the principal can costlessly distinguish the payoﬀ characteristics of the universe of securities in the ﬁnancial markets. 6 . s). where u(·) and v(·) are independent of states. then the contract can no longer specify the agent’s security selection in an eﬀective manner. Li and Zhou (2005) study a case in which the only way for the principal to get the agent to select a correct portfolio is to relate her pay to the realization of the portfolio return. A compensation scheme speciﬁes the agent’s wage as a function of the observed ﬁnal wealth and the signal y(w. we focus on the use of imperfect information for the eﬃciency improvement of the contract. Let the principal’s utility function be u(·) and the agent’s utility be v (·) . then there exists a unique state price function p (ω) per unit probability over Ω. However. where 0 < α(w. We also assume that the utilities are twice diﬀerentiable. which is random. It can be interpreted as a large investor hiring a money manager to manage 6 The diﬀerentiability are not necessary but for convenience. To be more speciﬁc. When α(w. s) − y(w. If a market is complete. a signal s(ω). s). Thus. s) = w.6 and their ﬁrstorder derivatives satisfy u (∞) = v (∞) = 0. Under this circumstance. can be observed by both the principal and the agent (common knowledge and veriﬁable). If the agent’s action can be observed. increasing and concave over the interval [0. and can consequently be contracted upon. the principal must design a compensation scheme in a way that indirectly gives the agent an incentive to select the correct set of securities. if it is too costly for the principal to distinguish the payoﬀ characteristics of the universe of securities. s) ≤ w. In this paper. If the ﬁnal wealth is w. or individual security selections in the portfolio. let w ≥ 0 be the ﬁnal wealth of the selected portfolio and w (ω) be the realization of the ﬁnal wealth over Ω.markets under consideration are complete. which is observable. the incentive scheme designed by the principal matters in order to motivate the agent to act in the best interest of the principal. The portfolio returns are aﬀected by the agent’s actions. then the contracting problem between the principal and the agent would be relatively straightforward. the contract would simply specify the exact portfolio of securities to be selected by the agent and the compensation that the principal promises to provide in return should the order be followed exactly. In addition.
Formally. ˆ Ω (4) where equations (3) and (4) are the standard participation constraint and incentive constraint. s) . Given a compensation scheme y (w. The principal will delegate an initial wealth w0 for the agent to manage. there exists an explicit conﬂict of interests between the principal and the agent. α(w. s)) dP (ω) ≥ v0 Ω (3) and w(ω) ∈ arg maxw(ω)∈A ˆ v(y(w(ω). Therefore. (1) where the last term in equation (1) is the budget constraint. The solution y(w.7 In general. 7 . s) − y(w. s) to this contract problem is the second 7 Much work in this literature has been done under such a speciﬁcation. and it is interesting to see how the principal and the agent share the risks and what the optimal contracts are. s)) dP (ω) Ω (2) subject to v(y(w. In other words. the action space A consists of all random variables over Ω that satisfy the budget constraint. In contrast to those onedimensional (or lowdimensional) action spaces studied in the agency models in existing literature.s). To formalize these ideas. s) is used to model a situation in which the principal may be an institution or may act as an agent of large number of investors. the model goes as follows: y(w. s)) dP (ω).g. a contract between a fund company and investors) or implicitly through the ﬂow of new funds. under the budget constraint. and thus only receive a portion of the realization of the ﬁnal wealth either explicitly as a management fee (e. and Carpenter (2004) and the references therein. See Dybvig.. s) to induce the agent to act in her best interest.his portfolio. Farnsworth. let the agent’s action space A be deﬁned by A = {w (ω) ≥ 0 Ω p(ω)w(ω)dP (ω) ≤ w0 }.w(ω) max u(α(w. respectively. ours is “large” in the sense that it is inﬁnite dimensional. the agent will select a portfolio such that his own expected utility is maximized. Let the agent’s reservation utility be v0 . and design a pay schedule y (w.
y(w. Following Li and Zhou (2005). Note that fs . The contracting problem above can be rewritten in terms of distribution conditional on the signal s. (8) For the case in which no signal s is involved in the pay schedule y.s). 8 .w(ω) max ds fs (s) Ω u(α(w. given our model setup in that both the principal’s utility and the agent’s utility are independent of state ω. s)) dP (ωs) ≥ v0 (6) and w(ω) ∈ arg max w(ω)∈A ˆ ds fs (s) Ω v(y(w(ω). we further assume fps is continuous and ﬁrstorder diﬀerentiable. Also let fw (w) be the distribution functions of wealth w (ω). s)) dP (ωs). respectively and use subscripts to distinguish diﬀerent variables. let fs and fp be the density functions of signal s and state price p. where fps (p) is the conditional probability density of state price p on s. hence fps are exogenously given. ˆ (7) where P (ωs) is the conditional distribution on s and the agent’s action space is rewritten as A = {w (ω) ≥ 0 ds fs (s) Ω p(ω)w(ω)dP (ωs) ≤ w0 }. We note that. s) − y(w. in the literature of portfolio choice without agency problem. but rather for convenience. and write the joint distribution of p and s as fs (s)fps (p). We will use f and F as probability density and cumulative distribution functions. Speciﬁcally. This is also true for portfolio delegations. For simplicity. the contracting problem (5)(7) is studied in Li and Zhou (2005). the state price density functions can not be arbitrarily speciﬁed. s)) dP (ωs) (5) subject to ds fs (s) Ω v(y(w. s) to (2) and (3) only is the ﬁrst best that is Pareto eﬃcient.best. we reformulate the model in terms of distributions. whereas fw (w) is the agent’s choice variable. that the states only need to be distinguished by the state price p and the signal s when the ﬁnancial markets are complete.8 8 These assumptions are not crucial to solve the contracting problems. there should be no arbitrage opportunity. whereas the solution y(w. it is wellknown. Relevant restrictions are given explicitly when we work with speciﬁc examples. In addition. fp .
Based on this observation. hence the principal’s problem represented by equations (5)(7) can be 9 . Lemma 1 is a straightforward extension of a similar result in Li and Zhou (2005) without a signal or information. (11) to rewrite the budget constraint in terms of wealth distribution. s)fps (p) dp ≤ w0 } (9) (10) where we have used the following −1 p = Fps (1 − Fws (w)). s(ω)) dP (ω) Ω exists. ds fs (s) pw(p.s)∈Ap fws (w)∈Aw max where Ap and Aw are deﬁned in equations (9) and (10). However. respectively. = = w(p. the optimal choice is always within the agent’s action space Aw . s)fws (w) dw. s) dP (ωs) max ds fs (s) ds fs (s) G(w(p). Notice that the optimizations are pointwise in the dimension of the signal s. and seems to be restrictive. Equation (11) implies that that w is a nonincreasing function of p that reduces the size of the agent’s action space. Lemma 1 Take an arbitrary utility function G(w.Now deﬁne feasible action spaces in the terms of state price and wealth distribution as Ap = {w(p. Now Lemma 1 enables us to reformulate the agent’s problem in the terms of wealth distribution. s) ≥ 0 and Aw = {fws (w) ≥ 0 ds fs (s) −1 Fps (1 − Fws (w))wfws (w) dw ≤ w0 }. Then w(ω)∈A max ds fs (s) Ω G(w(ω). s) such that w(ω)∈A max G(w(ω). s)fps (p) dp G(w. as shown by the following lemma.
the method we are going to use here is the basic technique in the calculus of variations. λf ) = ds fs (s) −λ + v(y(w. The details for applying this technique are provided in Li and Zhou (2005). the agent’s prob 10 . s)fws (w) dw. s) − y(w.fws (w) subject to ds fs (s) and fws (w) ∈ arg ˆ fws (w)∈Aw v(y(w. To solve the principal’s contracting problem. the maximization over signal s can be done statebystate or point maximization. for each s. Suppose that fws (w) is an optimal solution. The fact that fws is an optimal solution implies that all directional derivatives at fws for each s are zero. This observation simpliﬁes the problem signiﬁcantly. s) dw = 0 for each s.s). (15) where λ is positive constant and λf is a nonnegative function of wealth w and signal s. s))fws (w) dw (13) max ds fs (s) (14) To solve the principalagent problem (12)(14). we ﬁrst need to solve the agent’s problem. s))fws (w) dw −1 fws (w)Fps (1 − Fws (w))w dw − w0 ds fs (s) ds fs (s) λf (w. s). where (s) is a small constant for each s and η is an arbitrary integrable function that satisﬁes η(w. Such a restriction makes sure ds fs (s) [fws (w)+ η(w. The basic idea goes as follows. in which η is a directional vector. which is equal to zero if fws (w) > 0. λ. This is analogous to the ﬁnite dimensional case. That is. As indicated by the Lagrange V.reformulated as follows: max ds fs (s) u(α(w. s))fws (w) dw ≥ v0 ˆ v(y(w. s))fws (w)dw (12) y(w. then perturb fws (w) by (s) η (w. the resulting Lagrange of which is V(fws . s)] dw = 1.
All other feasible pay schedules have an equivalent “concave” pay that is diﬀerent only on the set of fws = 0. therefore. s)fws (w) dw. Suppose the agent’s problem has an optimal solution. s) = v(y(w. λ (s). s) is bounded above by a linear function for all s. s) − h(x(w. let x(w. In this case. s)}. 11 . Furthermore. The principal’s problem is then reformulated as follows10 x. 10 The signals in α and in pay schedule y could be diﬀerent. s) ≡ λ ˜ −1 Fps (1 − Fws (t)) dt + λ (s).9 Then the necessary and suﬃcient condition for optimality is that. s)) concave in w. s)) for ﬁxed s. (16) where x(w. s)) and is an ˜ arbitrary number such that fws > 0. Lemma 2 makes it legitimate to use the ﬁrstorder approach in solving the contracting problem. s) = v(y(w. −1 fws (w)Fps (1 − Fws (w))w dw − w0 This problem is similar to what has been studied in Li and Zhou (2005). and a density function fws (w) ≥ 0 such that w x(w. h(x) is increasing and convex. fws (w) ≡ 0 for w ∈ {tv(y(t. Lemma 2 Given a pay schedule y(w. λ > 0. s)))fws (w) dw (17) For example.fws ∈Aw 9 max dsfs (s) u(α(w. there exist constants. Since v (y) is increasing and concave. s). y(w. Speciﬁcally. s))fws (w) dw + λ + λf (w. ˜ An immediate implication of Lemma 2 is that we can restrict our feasible pays that make the agent’s indirect utility x(w. s)).s2 and fs becomes a joint distribution of s1 and s2 . if y(w. s) = v −1 (x) = h(x(w. s)) = x(t.lem is equivalent to choosing fws (w) to maximize v(y(w. s) is the concaviﬁcation of the agent’s utility function v(y(w. for any s. then x(w. the contracting problem can be solved by perturbing fws1 . s) will have an optimal solution. This observation enables us to further simplify the principal’s problem by replacing the incentive constraint by equation (16).
s) and fws (w) to maximize his utility u subject to the ﬁrstorder condition constraint (18) plus the participation and budget constraints. there is a unique fws (w) that implements it. Indeed. On the other hand. Lemma 2 tells us that the principal only needs to focus on the class of nondecreasing and concave functions in the selection of x (w. there exists a unique x(w. to obtain additional features of the optimal contract. Of course. for any x(w. ˜ which is exactly what matters in our principalagent problem. then x (w. In other words. s) and a number λ > 0 there exists a 1 Fws (w) = 1 − Fps ( x (w. increasing and concave indirect function x(w. x (w. If x (w. we need to solve the principal’s maximization problem. (18) where λ > 0 and λ (s) are free variables. s) is concave and nondecreasing for each s. distribution function 12 . which are constrained by ds fs (s) x(w. for any distribution function fws (w) and λ > 0. Our discussions so far lead us to conclude that. on the one hand. s) . Equation (18) alone also reveals ˜ an important feature of the optimal contract. s) = x (w.subject to x(w. s). s)) (20) λ such that equation (18) is satisﬁed. s) that satisﬁes equations (18) and (19). s)fws (w)dw ≥ v0 . (19) The reformulation of the original problem leads to equations (17)(19). s) = λ w −1 Fps (1 − Fws (t)) dt + λ (s). That is. s) are identical in a distribution sense. for any smooth. s). s) and its concaviﬁcation x(w. in which the principal selects x(w. the optimal contract must be designed in such a way that the compensation is a nondecreasing function of the ﬁnal wealth.
the objective function U is a concave function of (λ. the participation constraint must be binding at optimum. (λ. and a density function fws (w). λw . λv . λw > 0. λ (s)) must satisfy the following ﬁrstorder conditions ∂U 1 =− ∂λ λ ds fs (s) fws (w)[x(w. λ. Proposition 1 For any given multipliers λw and λv . These two variables can be handled separately from the function fws (w) by point maximization. λ.1 The Optimal Contracts The SecondBest Contracts In this section we characterize the optimal contracts of the agency problem discussed in the previous section. the objective function U is also dependent on two choice variables λ and λ (s). λf ) = U s (fws . Deﬁne U s (fws . s))) fws (w) dw −1 fws (w)Fps (1 − Fws (w))w dw − w0 x(w. λw . λv ≥ 0. s)fws (w) dw − v0 λf (w. λv . At optimum. s) − h(x(w. λ . λw . the last equation implies λv > 0. s) − λ (s)][u h − λv ] dw = 0. λ (s)). s)fws (w) dw. λv . λ . Note that. that is. λ .3 3. λf )fs (s) ds. (22) ∂U = − fws (w)[u h − λv ] dw = 0 (23) ∂λ (s) for all s. In addition. and λf (w. λ. s) ≥ 0 if fws (w) = 0. (21) where λ > 0. λf ) = − λw + λv + u (α(w. This means that maximizing U is equivalent to maximizing U s for all s. 13 . in addition to the budget and the individual rationality constraints. The Lagrangian for the principal’s maximization problem is U(fws .
λ. However. s) − h(x)) is a concave function of (w. to ease the exposition. s) = 0. Then λf (w. we only focus on the interior solutions in this paper. Proposition 3 Suppose u(α(w. λ Deﬁne D(s) = {wβ − 2u h + (u [α − h x ] + (β − λv )x ) fps λfps < 0}. Taking derivatives with respect to w to the ﬁrstorder condition (24) implies that d[u + (λv − λw /λ) x] λ + dw fps (p) w [u h − λv ]fws (t) dt = 0. e. s) (24) +λ 1 fps (p) a (u h − λv )fws (t) dt da = c(s) 0 −1 holds almost everywhere. α is discontinuous and/or nondiﬀerentiable at some points. s) − h(x(w. λv . (26) where β = 2λv − λw /λ and the prime denotes the derivatives with respect to w.To determine fws . 0 (25) −1 where p = Fps (1 − Fws (w)). Proposition 2 Fixed (λw . this condition can handle corner solutions quite easily. λ (s)). The ﬁrstorder necessary condition for an optimal solution fws to the contract problem is that there exists a function c(s) such that u(α(w. where p = Fps (1 − Fws (a)). s))) + λf (w. we use a variational technique as illustrated in the case of the agent’s problem. x) for all s. a diﬀerential equation can be derived to further investigate the property of the optimal solutions. This diﬀerentialintegral equation becomes an ordinary diﬀerential equation by taking derivatives one more time and using the fact that 1 fws (w) = − fps (x /λ)x .g.. s) ≡ 0 for all (w. For the region(s) in which λf (w. As shown in Li and Zhou (2005). 14 . s) + λv − w λw λ x(w. s).
x ( )). (32) When we have solved for x(w. (29) and 0 ∞ fps (x /λ)x [u h − λv ] dw = 0. satisﬁes the following ordinary diﬀerential equation (ODE) [β − 2u h ] x + u [α − h x ] − u h [x ]2 + u α + x (u [α − h x ] + (β − λv )x ) fps (p) λfps (p) = 0. s)). The ﬁrstorder conditions for (λ. given a set of boundary conditions (x( ). the optimal pay schedule is given by y = h(x(w. And the budget and participation constraints become ∞ (30) ds fs (s) 0 wfps (x /λ)x x dw = −λ2 w0 (31) and ds fs (s) 0 ∞ fps (x /λ)x x dw = −λv0 . (28) + v y + v [y ]2 (u [α − y ] + (β − λv )v y ) where p = v y /λ. where α is the ﬁrstorder derivative with respect to w. where p = x /λ. (27) 2 which has a unique solution in D(s). λ (s)) in equations (22) and (23) can be rewritten as follows ds fs (s) 0 ∞ fps (x /λ)x x[u h − λv ] dw = 0. x = v(y). s). the agent’s indirect utility. The optimal pay schedule y also satisﬁes an ordinary diﬀerential equation (ODE) as: (βv − 2u )y + v (βv − u )[y ]2 + u [α − y ]2 + u α v fps (p) λfps (p) = 0. for each s. it seems to be easier to work with the agent’s indirect utility x. However.In addition. 15 . The contracting problem can be solved by solving the ODE (27) and the multipliers are determined by the following integrals.
s) in the maximization problem (33)(34). However. which together with w(ω) solves the maximization problem (33)(34). s))fws (w) dw ≥ v0 . can be written as y(w(ω). λf ) = Ls (fws . λf )fs (s) ds.s) max ds fs (s) u(α(w. s) − y(ω)) dP (ω) Ω (33) subject to the participation constraints: v(y(ω)) dP (ω) ≥ v0 . Then. In addition. λv . s) = h(x) = v −1 (x). Then the Lagrangian of the reformulated maximization problem is as follows: L(fws . and a pay schedule y(ω) such that the pair (w(ω). it is helpful to reformulate the problem into the principal’s choosing the distribution of wealth fw instead of w. which is equivalent to a detailed instruction of portfolios. Lemma 3 shows we can replace y(ω) by y(w(ω). The ﬁrstbest contract consists of a ﬁnal wealth function w(ω). λv . s) − y) is concave for all s and y. λw . s) is convex. but it becomes complicated when α(w. Therefore. s) − y(w. y(ω)) maximizes the principal’s expected utility under the budget constraint: w(ω)∈A. λw . we cannot directly apply Lemma 1 to transform the problem into choosing fw because of the additional term y(ω). Lemma 3 The ﬁrstbest pay schedule y(ω). Ω (34) This maximization problem is straightforward when u(α(w. we use y(w. y(w. applying Lemma 1 to u + λv implies that the ﬁrstbest contracting problem is equivalent to fws (w)∈Aw .2 The FirstBest Contracts It is clear that the secondbest contracts are equivalent to the ﬁrstbest one if the signal s is the same as the underlying state ω. and for the sake of comparison with the case of the second best. y(ω) max u(α(w(ω). x. x. s))fws (w) dw subject to ds fs (s) v(y(w. s).3. 16 .
the corner solutions are quite straightforward for the ﬁrstbest case. s) . s)) is a ﬁrstbest solution to the principal’s problem if and only if it satisﬁes the following ﬁrstorder conditions w u(α(w. s)+λf (w. where C(s) is independent of w Similar to the secondbest case. x. λw . s) − h(x))h (x) − λv ] fws (w) = 0 almost everywhere for any and x. s) − h(x))fws (w) dw − λw + λv −1 Fps (1 − Fws (w))wfws (w) dw − w0 xfws (w) dw − v0 + f ηf (w. s)fws (w) dw. However. that is. Corollary 1 If λf (w. Thus λf for the ﬁrstbest case can be predetermined hence the interior part of the solutions are solved by simpler conditions. replacing u + λv x + λf in equation (35) by the concaviﬁcation of u + λv x along the dimension w. s) = [v ]−1 17 λw p λv α (w. s)))+λv x(w.where Ls (fws . Proposition 4 A pair (fws . s) λf (w. s)fws (w) dw < ∞. s). the ﬁrstorder condition (35) can be used to handle corner solutions. s)−h(x(w. and x by x ηx (w. s) = 0 at (w. s). then the ﬁrstbest contracts are given by y(w(p). we immediately have the following. x(w. λf ) = u(α(w. Using the variational method that perturbs fws by where f and x are two constants and ηf (w. s) dw = 0 and ηx (w. λv . (36) such that fws ( ) > 0. s)− λw and −1 Fps (1−Fws (t)) dt = C(s) (35) [u (α(w.
A formal statement of this observation is as follows. Corollary 1 also reveals another interesting implication of the model. An important and interesting question in portfolio delegation is: what state variables can be contracted upon? In practice. x) for all s. then the secondbest contracts are the same as the ﬁrstbest contracts. s) . To achieve the ﬁrstbest results. 3. Corollary 1 shows that the ﬁrstbest contracts have closedform solution for many types of utility functions. s) + [v ]−1 λw p λv α (w. The ﬁrstbest contracts do not depend on any signals if the gross beneﬁt of the principal α does not depend on a signal even they are deﬁned on a ﬁner partition of the state space than the state price. s) = [u ]−1 λw p α (w. the class of power utilities.3 Information and Eﬃciency From the formulations of the contracting problems. all it needs is the distribution of the state price if it can be contracted upon.g. s) − h(x)) is a concave function of (w. s). one may expect that since the security 18 . s) ≡ 0 for all (w. then λf (w. That is the secondbest contracts are the same as the ﬁrstbest ones. s) is the ﬁrstorder derivative with respect to w. However. the secondbest contracts can be improved by conditioning on some signals even though they may not be perfect substitutes for the state price.and the ﬁnal wealth is implicitly given by α(w. where α (w.. Theorem 1 If fps (p) is singular. If u(α(w. e. and λw and λv are determined by the budget and participation constraints. In addition. it is clear that if the signal s represents a ﬁner partition on the state space Ω then the ﬁrstbest contracts are achievable.
and other market imperfections prevent us from using all price information in the design of compensation schemes. In our continuoustime model. easy enforcement. such an index of the market portfolio may not exist or the market portfolio is not observable in reality. but rather we will develop a speciﬁc model to highlight some important points our approach can address. which is random. where passive indexes as contractible signals and manager’s dynamic portfolio selection issues can be addressed explicitly. In addition. While introducing an 19 . many pay contracts use some passive indexes as a benchmark in the design of compensation schemes because of high liquidity. In practice. However. In this section we will not seek generality in applying our approach. then how and in what degree are these imperfect signals able to improve the secondbest results? To further explore this and other contracting issues as well as to illustrate how the model can be applied. and low contracting costs of these passive indexes. they can thus be contracted upon. we will go through a detailed example in a continuoustime setup. a fund under management normally has an external fund inﬂow or outﬂow in the process of portfolio selection. the principal (investors or a fund company) hires a manager to manage her initial wealth w0 at time 0 and the ﬁnal wealth under the manager’s management at time T. the time horizon is [0. Theorem 1 shows that we do not need such full price information to achieve the ﬁrstbest results. casual observations tell us that practical pay schedules are hardly contracted upon all the perceivable contingent price states. 4 An Example in ContinuousTime Our analysis in the previous sections can be carried over to a continuoustime model. Enforceability. If these indexes are not perfect substitutes for the state price itself. which is widely used in modeling the dynamics of securities prices. However.price (or returns) processes can be observed. then the ﬁrstbest results are always achievable by writing contracts based on this index. which is perfectly correlated with the state price. In practice. T ]. is denoted by w = WT . Such a model is also more relevant in reality. If there exists an index of market portfolio. liquidity.
and B are the transpose of N dS 1 . dSN S1 S . .. and the others are N risky securities. S (37) µ.exogenous fund ﬂow causes no additional conceptual diﬃculty... Bd ) respectively. throughout this section we assume that the manager’s trading strategies are selfﬁnanced.. One is a riskfree bond. Note that B is a standard Brownian motion in Rd on a probability space (Ω. where π i is the fraction of total wealth held in the ith risky security. . and σ is a N × d matrix. Note that the manager’s trading strategy π .. µN ) and (B1 . We assume that the bond’s price St0 follows a deterministic process and has a constant short rate r. In other words. A manager’s trading strategy is an admissible process π = π 1 .. Given a trading strategy. Under such a condition. F.. We will further assume that the ﬁnancial market is complete. P ) . thus cannot be contracted upon. S where dS . Given our model setup. (39) (38) where 1 is a vector with all elements 1.. For the N risky securities. dS 0 = rS 0 dt.. . thus set d = N without loss of generality. the density process ξt at time T for the equivalent martingale measure is given by ξT = exp − 1 θ 2 T − θ BT 2 20 .. π N progressively measurable with respect to the ﬁltration Ft and satisﬁes T that is E 0 π 2 dt <∞ almost surely.. we assume away the external ﬂow issue for simplicity... There are N+1 securities available in the market for the manager to trade... W0 = w0 . S(0) > 0. S N ) is assumed to follow a multidimensional geometric Brownian motion dS = µdt + σdB. their price process S = (S 1 . (µ1 . . σ is a N × N matrix with a full rank. . with the standard ﬁltration denoted by Ft . then the corresponding total wealth process as follows dWt = r + π (µ − r1) dt + π σ dB. Wt cannot be observed by the principal.
if not impossible. and the principal and the fund manager maximize their expected utility functions based on the ﬁnal wealth at time T and the relevant information s. The gross return for this index over a period [0. (41) σθ where ρ = − πsp σs is the correlation between p and s. 1 which follows a normal distribution with a mean of µs = πs µ − 2 σ πs 2 T and a √ variance of σs = σ πs T . can be available for contracting. Therefore. to contract upon all security prices due to liquidity problems or other market imperfections. s) based on the ﬁnal wealth and security price information s. Since p and s is joint normal. ln p − µp σp 2 . Thus a contract can use the σ return of such an index to improve the eﬃciency. however. A trading strategy πs such that i πs = 1 forms an index whose return follows a geometric Brownian motion by equation (38). together with the wealth process. the principal designs compensation schemes y (w. practitioners typically design their contract based upon the ﬁnal wealth and a set of actively traded passive index funds (or portfolios of securities).1 Stock Index A passive index is formed by a subset of the N stocks. 21 . all security price processes. it is very costly.where θ = σ −1 (µ − r1). In practice. T ] is given by Rs = exp πs µ − 1 σ πs 2 2 T + πs σBT . where s could be the information generated by a set of security (or portfolio) price processes. and the corresponding state price density function fp (p) can be written as 1 1 fp (p) = √ exp − 2 2πσp p √ θ 2 T and σp = θ T . 4. Ideally. the conditional distribution of state price p on the signal s = ln Rs is fps (p) = 1 exp − 2 2(1 − ρ2 )σp 2π(1 − ρ2 )σp p 1 σp ln p − µp − ρ [s − µs ] σs 2 . (40) where µp = − r + 1 2 Similar to the static case in the previous section. The associated (deﬂated) stateprice p at time T is p = e−rT ξT .
we know that the trading strategy for such an index is γm σ πs = θ. 11 See. 4. and is determined by the price parameters only.11 This index is also known as the market portfolio in the asset pricing literature. and hence can be used in contracts. (42) Note that πs is a constant. From the discussion above. we only need to solve the ﬁrstbest contracts. where R0 = exp and γm = 1 σσ −1 1 (43) πs µ− r1 γm − 1 2γm 1+ 1 γm 2 σp T (µ − r1) .2 Market Portfolio As a benchmark. We also assume that the gross payoﬀs to the principal is: α(w. As shown in Theorem 1 the secondbest contracts are the same as the ﬁrstbest ones for this case. Merton (1971. The relation between the state price p and the return of the market portfolio is Rs = R0 p− γm . where γm is a constant scaler. The parameter γm can be interpreted as the relative risk aversion coeﬃcient of an investor who optimally invests all wealth in the stocks. e. This shows the trading strategy for this index is πs = σσ −1 (µ − r1) (µ − r1) 1 [σσ ] −1 .g.A special case in which an index is perfectly correlated with the state price oﬀers an ideal solution to the ineﬃciency of the secondbest contracts if such an index exists and is observable. s) = α0 w + α1 (w − w0 Rs eµ T )+ = w0 [α0 R + α1 (R − Rs eµ T )+ ]. 22 .. we ﬁrst study the contracting problem in the case in which there is a market portfolio that is observable. so. 1973). preferencefree.
Coupling these equations with the ﬁrstorder conditions in Proposition 4 gives us the solution of the ﬁrstbest contracting problem. s) − y (wl . u [α (wl . s) − y(wl . s) (44) u(α(wh . which are one of the direct implications of equation (35) in Proposition 4. wh − wl Here fws (w) ≡ 0 on the interval (wl . Since the gross payoﬀ of the principal is convex. s) − y(wh . This can be done by setting the following equations. s)) + λv v(y(wh . s)) − u(α(wl . 1 − γa (45) This seems to be a sensible way of deﬁning agents’ reservation because agents are competing with pay levels rather than utility levels in the markets for money managers. The optionlike pays capture some incentives or the eﬀects of fund ﬂows. wh ). s) = u [α (wh . s)] + λv v y (wl . Let us consider a speciﬁc example in which both of the principal and agent have a power utility as w1−γ . 12 The ﬁrstbest contract for the case of an arbitrary benchmark portfolio is also straightforward as given in Corollary 1. 1−γ Let γp and γa be the relative risk aversion coeﬃcient of the principal and the agent. 23 . We also use a certain equivalent pay wr to express the reservation of the agent. we have to concavify the welfare function u + λv v for each Rs . Due to the endogeneity of the multiplier λv and the pay schedule y. s)] + λv v y (wh . respectively. s)) = . which is deﬁned as solving 1−γ wr a = v0 .where R = WT /W0 and Rs is the gross return of the market portfolio.12 given by equation (43). s)) − λv v(y(wl . and µ is a constant. this concaviﬁcation cannot be done without solving the contracting problem. s) − y (wh .
σp γ (48) where N (·) is the cumulative distribution function of a standard normal random variable. ¯ and p. ¯ α0 + α1 1−γp 2 σp 2γp e − 1−γp γp ” α0 a 1 −1 γp [1 − A (γp )] + (α0 + α1 ) 1 −1 γa 1 −1 γp A (γp ) 1 −1 γa 1 −γ λw p +e 2 − 1−γa (µp − 1−γa σp ) γ 2γ a α0 [1 − A (γa )] + (α0 + α1 ) A (γa ) λw λv − γ1 a + e− and e 1−γm γm 2 (µp − 1−γm σp ) α1 w0 R A (γ ) = w . Then the optimal pay schedule is given by 1 λw p − γ a if p ≥ p ¯ λv α 0 y(p) = 1 −γ a λw p if p < p ¯ λv (α0 +α1 ) and the ﬁnal wealth is given by 1 −γ − γ1 1 p a λw p λw p + λv α0 α0 α0 w(p) = 1 −γ 1 1 p λw p + α1 w0 R p− γm + α0 +α1 α0 +α1 where R = R0 eµ T if p ≥ p ¯ λw p λv (α0 +α1 ) − γ1 a if p < p. λw .Corollary 2 Suppose that both the principal and agent have power utility and the market portfolio is observable. 2γm m 0 α0 + α1 (47) 2 − 1−γa (µp − 1−γa σp ) γ 2γ a a α0 1 −1 γa [1 − A (γa )] + (α0 + α1 ) 1 −1 γa A (γa ) λw λv 1− γ1 a = (1 − γa )v0 . and λv are determined by the system of equations: ¯ − α0 1 −1 γp 1 −γ − 1 γa γp λw p p γp + ¯ 1 − γp 1 − γa (α0 + α1 ) = “ µp − 1 −1 γp λw λv − γ1 a p− γa ¯ (46) 1 α1 w0 R − γ1 p m. 24 . where A(γ) = N ln p − µp 1 − γ ¯ + σp .
we also call this relation the ﬁrstbest contracts. This is the result of the optimal risk sharing between principal and agent. The gap in the graph represents the region of {wfws (w) = 0} caused by the covexity of α(w. σs = 30%. respectively. Without confusion.5 Figure 1: Firstbest contracts against ﬁnal wealth with the same reservation.5.w0 Rs)+ α(w. Figure 1 plots the ﬁrstbest contracts in the case in which the principal (a fund company or an individual investor) is more risk averse than the agent.5 2 2.02 0. Intuitively.02 w α(w. both pay schedule and ﬁnal wealth are monotone functions of state price. s) = 0. s). This is especially useful in comparisons between the ﬁrst.3.015 0. the ﬁrstbest pay schedule becomes concave if the agent is more risk averse than the principal 25 .01 0. 0. Hence there is a unique relation between pay schedule and ﬁnal wealth. µs = 10%. Both ﬁnal wealth and pay schedules are normalized by the initial wealth. s) = w 0.Under the ﬁrstbest contracts.5 1 1.02 w + 0.and secondbest contracts. The parameters are: σp = 0.03 0. s) = 0. Preferences are power utilities and the relative risk aversion coeﬃcients of the principal and agent are γp = 3 and γa = 0. The following graphs illustrate this relations for two numerical examples.025 0. This plot shows that the agent takes more risk by oﬀering a convex pay schedule.05 (w .005 0 0.035 α(w. r = 5%.
s) = 0. The gap in the graph represents the region of {wfws (w) = 0} caused by the covexity of α(w. r = 5%.g. Both ﬁnal wealth and pay schedules are normalized by the initial wealth.as illustrated in Figure 2.008 0.006 0.5.009 α(w. s). 0. s) = 0. Such sensitivities are solely due to the optimal risk sharing and becomes a constant if both principal and agent share the same preferences.003 0. Although there is no incentive concern in the ﬁrstbest contracts. respectively. µs = 10%.02 w + 0. e. the ﬁrstbest pay schedule may be very sensitive to the performance of a delegated portfolio..05 (w .007 0. s) = w 0. The parameters are: σp = 0. 26 .005 0.3 and γa = 3.004 0. then diﬀerent pay contracts across fund companies are simply the results of diﬀerent risk attitudes among fund companies and managers.002 0 1 2 3 4 5 6 Figure 2: Firstbest contracts against ﬁnal wealth with the same reservation. Preferences are power utilities and the relative risk aversion coeﬃcients of the principal and agent are γp = 0. σs = 30%. If the ﬁrstbest model presented here is a good approximation for some of the delegated portfolio management.02 w α(w.w0 Rs)+ α(w. existing a good proxy for the market portfolio.
27 . the market portfolio is not observable due to various reasons. By equation (41). we have fps (p) fps (p) =− 1 2 (1 − ρ2 )σp p ln p − ρ σp s − µps . In this case. σs (49) 2 where s = ln Rs and µps = µp − ρ σp µs − (1 − ρ2 )σp is a constant. it is not obvious to choose starting values. Substituting this σs into the ODE (27) and using p = x /λ yields.3 Imperfect Signals In practice. we have to seek the secondbest solutions. Due to the numerical complexity. hence an index with a subset of stock is used in the contracting problem. If x is a secondbest solution to the contracting problem. we only consider a simple case in which α(w. Because the righthand side of the ODE is positive and x ≤ 0. λv ). then u [α0 − h x ] + (β − λv ) x −→ 0 as w goes to ∞. (51) The secondorder ODE (50) can be solved numerically by transforming it into a system of ﬁrstorder ODEs given a set of boundary conditions. the solution has to satisfy the constraint β − 2u h − u [α0 − h x ] + (β − λv )x 2 (1 − ρ2 )σp x ln x − ρ σp s − µps − ln λ σs < 0.4. Lemma 4 Given (λ. β − 2u h − u [α0 − h x ] + (β − λv )x 2 (1 − ρ2 )σp x 2 ln x − ρ σp s − µps − ln λ σs x (50) = − u [α0 − h x ] + u h [x ]2 . λw . the asymptotic behavior of the ODE can be obtained by combining it with the diﬀerentialintegral equation (25). Because the ODE contains parameters that are determined endogenously. s) = α0 w. However. for each s.
the cumulative distribution conditional on the benchmark returns for 1% and 99% is also ploted in the graph.005 0 0. both the ﬁrst. against the ﬁnal wealth. respectively. where the secondbest pay schedules are conditional on the returns of the benchmark index.8.3. In the ﬁrst example.and secondbest.02 0.02w. The model parameters are stated in the ﬁgures captions. r = 5%.5 2 2.01 0. Label “s” represents the secondbest conditional on returns of a benchmark portfolio and “P” represents the conditional cumulative probability distributions of ﬁnal wealth.5.This lemma sets additional constraints on the feasible solutions to the ODE.015 0. Figure 3 plots the optimal contracts. One of the striking features of the secondbest contracts 28 . Preferences are power utilities and the relative risk aversion coeﬃcients of the principal and agent are γp = 3 and γa = 0.5 3 Figure 3: Optimal contracts against ﬁnal wealth. Both ﬁnal wealth and pay schedules are normalized by the initial wealth. The parameters are: σp = 0. The gross beneﬁt of the principal α(w) = 0.03 Firstbest P = 1% P = 99% s = 50% s = 38% s = 26% s = 14% s = 02% s = 10% s = 22% s = 34% s = 46% s = 58% s = 70% 0. 0.025 0. We present two numerical examples in the following. In addition. σs = 30%. µs = 10%.5 1 1. the principal is assumed to collect a 2% fee on the ﬁnal wealth from the fund investors. and ρ = 0. Such constraints make the searching a numerical solution much easier.
00% P = 99. The benchmark makes the secondbest contracts more 29 .0022 0. Label “s” represents the secondbest conditional on returns of a benchmark portfolio and “P” represents the conditional cumulative probability distributions of ﬁnal wealth. and ρ = 0. This indicates managers will not get large rewards for dazzling performance relative to the benchmark.5 0.8.00215 0.18% P = 1. Another interesting feature to notice is the similarities between the contour curves for ﬁxed conditional cumulative probabilities. However.5. This illustrates the role of the benchmark in designing the secondbest contracts. Both ﬁnal wealth and pay schedules are normalized by the initial wealth.00205 s = 9. Preferences are power utilities and the relative risk aversion coeﬃcients of the principal and agent are γp = 3 and γa = 0.g.02w. µs = 10%.5 2 2. 0.002 Figure 4: Secondbest contracts against ﬁnal wealth. The gross beneﬁt of the principal α(w) = 0. the curve with P = 1% in Figure 3. and the ﬁrstbest pay schedule.00% 1 1. respectively.. The parameters are: σp = 0.0021 0. r = 5%.94% s = 10.3. e.06% s = 10. they do get hefty rewards when the returns of the benchmark are high even the return of the managed portfolio is below the benchmark.5 3 3.is the ﬂatness conditional on the benchmark returns within a reasonable range of portfolio returns. σs = 30%.
especially in the reasonable range of portfolio returns. Although. Of course the ﬂatness of the secondbest contracts is only a relative term. For example. the principal is less risk averse. This is why they look very ﬂat in Figure 3. The latter means designing a pay schedule such that eﬀective preferences for the agent. optimal risksharing is to let the less riskaverse party take more risk. the conditional secondbest contracts are quite similar in terms of ﬂatness and concavity. v(y).ﬁrstbest like. All qualitative observations we have discussed for the previous case are exactly applied here. As shown in the case of ﬁrstbest contracting problem. as indicated by Figures 1 and 2.. The less sensitivity to the benchmark is due the less divergence of preferences between the principal and agent. one is the risksharing. the similarity condition requires that the less riskaverse party taking more risk. Figure 4 further illustrates the detailed secondbest contract conditional on particular levels of the benchmark returns. These two opposite condi30 . The usefulness of the benchmark is determined by the correlation between the benchmark and state price. Such eﬃciency gains are also evident by the clear separations of the conditional pay schedules. hence the eﬀective preferences after splitting the gross returns are similar.g. the pay should converge to 0 with the gross return. At this time. the other is the similarity. too. Figures 5 and 6 replicate the previous two plots but with diﬀerent preferences and gross beneﬁt of the principal (e. The plots truncate the pay schedule to illustrate its insensitivity to returns in a reasonable range. There are two opposite forces working against each other in the secondbest contracting problem. and thses two kinds of contracts become exactly the same when the return of benchmark is perfectly correlated with the state price. is similar to the principal’s. It is obvious that the conditional pay schedules are concave but the absolute variations are quite small. a wealthy individual investor). However. the shapes of the ﬁrstbest contracts are quite distinguished by the relative risk aversion between the principal and agent. This is of course an indication of eﬃciency improvement by incorporating the benchmark in designing the secondbest contracts. the conditional pay schedules get closer with a lower correlation.
0009 s = 40% s = 30% s = 20% s = 10% s = 00% s = 10% s = 20% s = 30% s = 40% s = 50% 0. the ﬂatness is also prevalent in the case in which the state price follows a uniform distribution. respectively.0.0005 0 0.5 2 2. This qualitative feature of the secondbest contracts also holds for the ones without any signals. σs = 30%. Preferences are power utilities and the relative risk aversion coeﬃcients of the principal and agent are γp = 1. the second31 .0008 0.5 Figure 5: Optimal contracts against ﬁnal wealth. as shown in Li and Zhou (2005). The parameters are: σp = 0.0012 Firstbest P = 01% P = 99% 0.5. especially in comparison to the ﬁrstbest contracts.5 1 1. tions make the secondbest contracts ﬂat. Both ﬁnal wealth and pay schedules are normalized by the initial wealth. Again.001 s = 60% s = 50% 0.5 and γa = 3. we cannot conclude that they are always concave.0007 0. µs = 10%. which aﬀects the relative strength between risksharing and preference similarity. and ρ = 0. Although the secondbest contracts are concave in the reasonable range of portfolio returns for the two examples.8. Label “s” represents the secondbest conditional on returns of a benchmark portfolio and “P” represents the conditional cumulative probability distributions of ﬁnal wealth.0011 s = 70% 0. The gross beneﬁt of the principal α(w) = w. As shown in Li and Zhou (2005). r = 5%. and it also depends on the level of reservation.0006 0.5 3 3. especially for extreme returns.
we notice that the shape of the secondbest contract in the classical principalagent models with moral hazard is steeper than that of the ﬁrstbest contract.8. as the investor does not have 32 . and ρ = 0.00079239 0. As a ﬁnal note.00079241 0. r = 5%. This is consistent with our intuition. best contracts can be a combination of locally concave and convex curves. Preferences are power utilities and the relative risk coeﬃcients of the principal and agent are γp = 1. such an inquiry. In contrast.5. which calls for a rigorous analytical treatment of the ODE and a tailormade numerical method.00079237 s = 10% P = 1% P = 99% 0 1 2 3 4 5 6 7 8 Figure 6: Secondbest contracts against ﬁnal wealth. A more detailed study of the secondbest contracts is interesting.00079242 0.5 and γa = 3. Both ﬁnal wealth and pay schedules are normalized by the initial wealth.00079238 0. respectively. σs = 30%. µs = 10%. the shape of the secondbest contract in our context is ﬂatter than that of the ﬁrstbest contract. The gross beneﬁt of the principal α(w) = w. However. is outside the scope of this paper.0007924 0. since the principal needs to motivate the agent to exert a high eﬀort.0. Label “s” represents the secondbest conditional on returns of a benchmark portfolio and “P” represents the conditional cumulative probability distributions of ﬁnal wealth. The parameters are: σp = 0.
or eliminate when properly constructed. Doing so would shed light on the nature of contracts for the managers of “actively” managed funds. the market portfolio may not be observable. In this case the magnitude of eﬃciency improvement depends on how close the stock index is to the market portfolio. Then. they can help to reduce. Stoughton (1993). 5 Conclusion The stock indexes are created for many diﬀerent purposes. As mentioned earlier. e. agency costs when the fund manger’s portfolio choice cannot be contracted upon. The true role of benchmarks in the design of optimal compensation schemes in this rich environment is still not well understood. a close substitute. and a lot of work is left to be done along this line.to motivate a high manager’s eﬀort. which would be a complement to what we have done in this paper. their conclusion is based on a given class of compensation schemes. This is a largely unexplored area. In this situation. The condition for a stock index to achieve the ﬁrstbest risk sharing is strikingly simple: it only needs to be a market portfolio. The next natural step to enrich our model would be to introduce the fund manager’s private information or other information structures into the analysis. can be used in the contract design. the fund’s total return plus the benchmark return can implement the ﬁrstbest contract. however. that is. and Admati and Pﬂeiderer (1997) point out some problems of the popular linear contract and benchmarks in the presence of private information. which is by deﬁnition perfectly correlated with the state price. However.. 33 . This diﬀerent prediction of the optimal contract shows the key diﬀerence between the model with eﬀort and the model with choice.g. In general. In this paper we show that one of their side eﬀects is socially valuable. a stock index.
This result is also used in solving the contracting problems later. s) dt = 0. 34 .1 For any given distribution function fws . −1 fws (w)Fps (1 − Fws (w))w dw. Lemma A. s) dt 0 dw. s) dw = 0. Then. s) is an arbitrary piece wise smooth function that satisﬁes ∞ η(w. ∞ w dE [pw] = d and d2 E [pw] = d2 where ds fs (s) 0 η(w. Proof. s). where is a constant and η satisﬁes η(t. Perturb the density function fws by η(w. s) −1 Fps (1 − Fws (t)) dt dw ∞ ds fs (s) 0 1 −1 fps (Fps (1 − Fws (w))) w 2 η(t. s)] dt = 0 ∞ 0 w [fws (t) + η(t. let E [pw] be the present value of the wealth under a perturbed density function fws = fws + η. Proof of Lemma 2 We need the following result ﬁrst to proceed the proof. 0 Let Fws denote the cumulative distribution function conditional on the signal s. s)] dt.Appendix: Proofs Proof of Lemma 1 See Lemma 1 in Li and Zhou (2005). Note that w ∞ 1 − Fws (w) = 1 − Let [fws (t) + η(t. where is a small constant and η(w. E [w] = s. −1 is an arbitrary number such that fws ( ) > 0 or Fps (1 − Fws ( )) is ﬁnite.
which equals zero when fws > 0 and is nonnegative when fws = 0. s) dt 0 dw. s)wFps (1 − Fws (w)) dw − ∞ 0 wfws (w) fps 0 w η(t. Finally. where λ is a positive constant and λf (w. s)fws (w) dw − λ ∞ 0 −1 fws (w)[Fps (1 − Fws (w))]w dw − w0 + 0 λf (w. s) da dw 0 1 −1 fps (Fps (1 − Fws (w))) η(t. s) da dt − 0 w fps 2 η(a. equals zero. following the procedure as described in the proof of Lemma 1. s) = v(y(w. taking derivatives to the above equation again and integrating by parts shows 1 fps t η(w. let fws (w) = fws (w) + η(w. [w] = d2 = 0 ∞ w ∞ w −1 Fps (1 − Fws (t)) dt dw. This shows that dE s. where 35 . s). Applying the integration by parts to the second integral of the right hand side yields ∞ 0 w wfws (w) fps tfws (t) fp dt 0 w η(t)dt dw w ∞ ∞ w = ∞ η(t) dt 0 0 − 0 η(w) tfws (t) fps dt dw = 0 −1 −1 η(w) wFps (1 − Fws (w)) − Fps (1 − Fws ( )) w − where is a positive number. the relation between E and E s. To maximize the Lagrangian given by (15) is to maximize the following: Vs = 0 ∞ ∞ x(w. Then. [w] = d that d2 E s.Then. where the term with the lemma. s) − 0 ∞ η(a. [w] = d ∞ 0 −1 η(w. leads to Let x(w. s)dt dw. s)). the ﬁrst derivative of the perturbed expected wealth is dE s. s)fws (w) dw. Then. η(w) 0 −1 Fps (1 − Fws (t)) dt dw. s) is a nonnegative function.
This shows that the Lagrangian V s always has an interior maximum and the ﬁrstorder condition w. s) x(w. d ∞ are = 0 η(w. s) ≡ c(s) (52) holds almost everywhere. = −λ d2 dV s. s) is nondecreasing and concave. Let λ (s) = x( . 36 . there exists a function Fws or fws such that equation (52) holds. Yet this is true if and only if there exists a function c(s) which does not depend on x(w. s) for each s. Otherwise. d ∞ 0 −1 −1 Fps (1 − Fws (t)) dt + Fps (1 − Fws ( )) dw. s) − λ −1 −1 Fps (1 − Fws (t)) dt − λ Fps (1 − Fws ( )) + λf (w. Then. it contradicts the ﬁrstorder condition. s) − λ Fp (1 − Fw ( )) = c(s) for all ∈ {t∞ > fws (t) > 0}. s) w − λ and d2 V s. s) and deﬁne w x(w. As x is bounded above by v(α(w. 1 −1 fps (Fps (1 − Fws (t))) w 2 η(t. s) is the smallest ˜ ˜ ˜ concaviﬁcation of x(w. s)). s) + λf (w.∞ 0 η(w. deﬁne the perturbed La∞ grangian as V s. s) dt 0 dw < 0. s) dw = 0 and fws is the optimal solution. s) + λf (w. = 0 [x(w. such that w  =0 = 0 is both suﬃcient and necessary when we restrict fws ≥ 0. s)] fws (w) dw ∞ −λ 0 −1 fws (w)[Fps (1 − Fws (w))]w dw . This equality and Lemma 1 imply that −1 x( . Using Lemma 1. As x(w. s) and x(w. x(w. s) = λ ˜ −1 Fps (1 − Fws (t)) dt + λ (s). the ﬁrst two derivatives of the Lagrangian with respect to dV s. s) ≤ x(w.
∂λ2 (s) ∂x 0 where the negativeness of the second derivatives is due to the fact that ∂[u h ] = −u [h ]2 + u h > 0. 2 ∂λ λ ∂x 0 ∞ ∂ 2U 1 ∂[u h ] = − ds fs (s) fws (w)[x(w. [pw] dw − λw . s) = λ w −1 Fps (1 − Fws (t)) dt + λ (s). denote the perturbed U s . Proof of Proposition 2 Let U s. Then the second order derivatives are given by ∞ ∂ 2U 1 ∂[u h ] = − 2 ds fs (s) fws (w)[x(w. d d (53) 37 . A direct calculation shows ∂2U ∂ 2U ∂2U − ∂λ2 ∂λ2 ∂λ∂λ (s) 2 > 0. λ (s)). that is U s. s) − λ (s)]2 dw < 0. the solution to the ﬁrstorder condition maximizes the objective globally and is unique. Then the ﬁrstorder derivative of U is dU s. s)[u + λv x + λf (w)] dw 0 ∞ + 0 fws d[u + λv x ] dE s. ∂x because both u and v are concave functions. Since this holds for any (λ.Proof of Proposition 1 The ﬁrstorder derivatives of U with respect to λ and λ are straightforward by noting that x(w. = 0 ∞ [u + λv x + λf (w)]fws dw − λw E s. ∂λdλ (s) λ ∂x 0 ∞ ∂2U ∂[u h ] = − ds fs (s) fws (w) dw < 0. = d ∞ η(w. [pw] + λw w0 − λv v0 . s) − λ (s)] dw.
38 . s) u + λv x + λf + λ 0 ∞ 0 w 1 fps 0 [u h − λv ]fws da dt dw (54) − λw 0 η(w. integration by parts shows ∞ 0 fws (w) ∞ d[u + λv x ] dw d w = λ 0 [u h − λv ]fws (w) w 1 fps 1 fps t η(a. s) da dt dw 0 t ∞ w = λ 0 [u h − λv ]fws (t) dt ∞ η(a. the ﬁrst derivative of U with respect to dU s. Note that the last two terms are equal to zero due to the ﬁrstorder conditions in Proposition 1. equation (23). using (18) or Lemma 2. Therefore. ∞ 0 w 1 fps t η(a. where we have use the ﬁrstorder condition for λ . s) da dt dw. = d ∞ w is: t η(w. s) da dt. 0 where we use the fact that the derivatives of λ and λ do not depend on w. s) −1 Fps (1 − Fws (t)) dt dw. s) dt 0 0 [u h − λv ]fws dt dw = λ 0 η(w.First note that. s) 0 1 fps [u h − λv ]fws da dt dw. s) da dt 0 w 0 −λ 0 ∞ w 1 fps t 0 w η(t. 0 fws (w) = λ d[u + λv x ] dw = − d ∞ ∞ 0 w [u h − λv ]fws 1 fps t dx (w) dw d 0 [u h − λv ]fws (w) η(a. Using this equation and Lemma 1. we have dx (w) = −λ d Then.
when dU s. s) −1 Fps (1 − Fws (t)) dt dw = 0 η(w. s) − h(x(w. Speciﬁcally. s) + λf (w. See Li and Zhou (2005) for the other results. s) λ (55) [u h − λv ]fws (a) da dt = c(s) holds almost everywhere. s) − w +λ 1 fps t 0 λw x(w. 39 . s) u + λv x + λf w + λ 1 fps t [u h − λv ]fws da dt − 0 λw λw x+ λ λ λ dw = 0. s) λ t 1 [u h − λv ]fws (a) da dt = c(s) fps 0 Proof of Proposition 3 The derivation of the secondorder ODE is straightforward. The above integral equals zero for any arbitrary η such that ∞ η(w.where we have used Lemma 1. s) − h(x(w. we have x = x and w = =0 0 η(w. where we ignore the constant terms. However. d ∞ = 0. λw x(w. s) dw = 0 0 if and only if there exists a c(s) that is independent of w such that u(α(w. where the second last equality is obtained by using the constraints (18) or Lemma 2. s) u + λv x + λf + λ ∞ w 1 fps t [u h − λv ]fws da dt dw 0 − λw 0 ∞ η(w. we have u(α(w. s))) + λv x(w. s))) + λv − w +λ when fws (w) > 0.
(56) 40 . Proof of Corollary 1 If λf (w. Proof of Proposition 4 Because x or (y(w)) is a free choice function. And for the case of x.Proof of Lemma 3 Let F (w. Then the two ﬁrstorder conditions in Proposition 4 become u α = λw p and u = λv v . w]) dFws (w). ys) dFws (w) u(α(w. fws > 0. s) − y(ω)) P (dω) Ω = = = ≤ ds fs (s) Ω u(α(w(ω). s)) − E[ys. We skip the details of the calculations. s) − y) dF (w. It is similar to the case of agent’s problem for fw . s(ω ) = s}. we then have u(α(w(ω). ys. ys) is the joint cumulative distribution function for given w(ω) ∈ A and y(ω) conditional on the signal s. The last inequality is due to Jensen’s inequality and becomes equality if y(ω) = y(w. This means the optimal pay takes the form of y(w. s) = 0. the maximization problem is quite straightforward. s) − y(ω)) P (dωs) u(α(w. w) ds fs (s) ds fs (s) ds fs (s) u(α(w. s) for all ω ∈ {ω (w(ω ) = w. the second order is due to that fact that u(α(w) − h(x)) is a concave function of x for any ﬁxed w. s). The second order is automatically satisﬁed by the budget constraint. s) − y) dF (w.
we have the pay schedule as given by y(w(p). s)) − u(α(wl . we / have u α = λw p and u = λv v . s)) wh − wl = λw p. s) − y(wl . then the third ﬁrstorder condition (24) becomes equation (35) in light of equation (18). s) − y(wh .Then it is straightforward to check that these two equations imply the pay schedule and the ﬁnal wealth in the corollary. by Corollary 1. s)) − λv v(y(wl . then fws (w) is also singular. s)) + λv v(y(wh . for any w ∈ (wl . Proof of Corollary 2 By Proposition 4. If fps is singular at s. Having recognized that u + λv x is concave in w if the condition is satisﬁed. where wl and wh satisfy equations (44). s(p)) = λw p λv α0 − γ1 a if w ≤ wl − γ1 a λw p λv (α0 +α1 ) if w ≥ wh and the ﬁnal wealth is given by 1 −γ − γ1 1 p a λw p λw p + λv α 0 α0 α0 w(p) = 1 −γ 1 1 p λw p + α1 w0 R p− γm + α0 +α1 α0 +α1 41 if w ≤ wl λw p λv (α0 +α1 ) − γ1 a if w ≥ wh . Also. . (57) where s = Rs is as deﬁned by equation (43). the second part follows immediately. Substituting these equation into equations (16) leads to u(α(wh . the ﬁrstorder conditions (22) and (23) hold only if u h = λv . Therefore. wh ). Proof of Theorem 1 It is trivial to examine the contracting problems or the ﬁrstorder conditions.
substituting these into (57) yields equation (46). Similarly. x = λp converges to 0 and best. Proof of Lemma 4 Since both fps and rule implies λ fps (p) w w [u 0 h − λv ]fws (t) dt converge to 0 as w goes to ∞. Then. for any γ. the pay schedule and ﬁnal wealth can be rewritten as in the the theorem. p ¯ 0 p fp (p) dp = √ −γ 1 2πσp ln p ¯ −∞ e−γx e − 1 2 2 (x−µp ) 2σp dx . the budget constraint is p ¯ ∞ w(p)pfp (p) dp + 0 p ¯ w(p)pfp (p) dp = w0 . 42 . ¯ Then. at by equation (58) and fps (p) fps (p) p ∼ − ln p . Given p. hence b has to equal 0. u h ∼ 1 p λfps (p) fps (p) λfps (p) . = exp −γ µp − and ∞ p ¯ 2 γσp 2 N 2 ln p − µp + γσp ¯ σp p−γ fp (p) dp = exp −γ µp − 2 γσp 2 1−N 2 ln p − µp + γσp ¯ σp gives us equation (47). fps (p) λfps (p) → b. equation (48) is also obtained from the participation constraint. Using the identities.Then. equation (25) shows u [α0 − h x ] + (β − λv )x → [u h − λv ] Suppose this converges to a constant b. That is u [α0 − h x ] + (β − λv )x → [u h − λv ] As w goes to ∞. L’Hopital’s λfps (p) fps (p) [u h − λv ]fws (t) dt → −[u h − λv ] 0 as w goes to ∞. In this case. fps (p) (58) converges to 0.
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