Adverse Risk Incentives and the Design of Performance-Based Contracts

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Abstract
In this paper, option pricing theory is used to value and analyze many performance-based fee contracts that are currently in use. A potential problem with some of these contracts is that they may induce portfolio managers to adversely alter the risk of the portfolio they manage. This paper is prescriptive, in that it derives conditions for contract parameters that provide proper risk incentives for classes of investment strategies. For buy-and-hold and rebalancing strategies, adverse risk incentives are avoided when the penalties for poor performance outweigh the rewards for good performance.
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