Asset pricing under optimal contracts (joint with Hao Xing, London School of Economics)

We consider the problem of finding equilibrium asset prices in a  financial market in which a portfolio manager (Agent) invests on behalf of an investor  (Principal),  who compensates the manager with  an optimal contract. We extend  a model from Buffa, Vayanos  and Woolley (2014), BVW (2014), by  allowing general contracts. We find  that the optimal contract rewards  Agent for taking specific risk  of individual assets and not only the systematic risk of the index by using the  quadratic variation of the deviation between the portfolio return and the return of an index portfolio.  Similarly to BVW (2014), we find that, in  equilibrium, the stocks in large supply have high  risk premia, while the stocks in low supply  have low risk premia, and this effect  is stronger as agency friction increases. However,  by using our risk-incentive optimal contract, the  sensitivity of the price  distortion to agency frictions  is of an order  of magnitude smaller compared  to the price distortion in BVW (2014), where only contracts linear in portfolio value and index are allowed.