OPTIMAL CONTRACTS AND ASSET PRICES IN A CONTINUOUS-TIME DELEGATED PORTFOLIO MANAGEMENT PROBLEM

Abstract

We study optimal contracts and asset prices in a financial market in which an investor delegates a portfolio manager to manage her wealth. The agency frictions are caused by the manager's "shirking" action and hidden effort. The shirking action converts part of the return of the managed portfolio into the manager's income without reducing his utility. The manager's effort improves the return of the portfolio but reduces the manager's utility. We illustrate this dynamic principal-agent problem under hidden effort and observable effort, respectively. When the effort is hidden, to alleviate the impact of moral hazard, the investor pays more for the manager's performance and always keeps the optimal contract related to the returns of the manager's portfolio and market portfolio, and their quadratic (co)variations. When the manager's effort is observable, the optimal contract is related to the return of the market portfolio if the agency friction caused by the shirking action is serious, but is only related to the return of the manager's portfolio if shirking is not serious. Analysing the expected utility of the manager, we find that he has a disposition to hide information about effort to pursue a higher expected utility