Managerial Incentives and Financial Contagion

IMF Working Papers, October 1, 2004

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Managerial Incentives and Financial Contagion

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Bibliographic details

• Authors: Sujit Chakravorti, Subir Lall
• Published: October 1, 2004
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781451860146.001

Summary and Research Question

• Proposes a framework for comovements of asset prices with seemingly unrelated fundamentals as an outcome of optimal portfolio strategies by fund managers.
• Investigates how, in emerging markets, interactions arise when dedicated managers seek to outperform a benchmark index and global managers maximize absolute returns, generating systematic interactions between asset prices without asymmetric information.
• Determines conditions under which shocks in one emerging market affect others.

Model Mechanisms and Key Findings

• Optimal portfolio strategies by fund managers can produce comovements in asset prices even when fundamentals are seemingly unrelated.
• The model determines:
  • Optimal portfolio weights for different manager types.
  • The incidence of relative value strategies.
  • The systematic deviation of prices from fundamentals given limits to arbitraging this differential.
• Dedicated managers (benchmark-relative) and global managers (absolute-return-maximizing) generate systematic interactions across asset prices through their incentive-driven trading behavior.

Managerial Compensation and Macro Inefficiencies

• Managerial compensation contracts that are optimal at the firm level can lead to inefficiencies at the macroeconomic level.
• These incentive-induced trading strategies can create price deviations from fundamentals that are hard to arbitrage away, producing persistent mispricings and potential channels for contagion.

Financial Contagion Conditions

• The paper identifies conditions under which shocks in one emerging market affect others, arising endogenously from managers’ portfolio choices and compensation structures rather than from information asymmetries.

Subject Areas and Keywords

• Subject: Asset prices, Currencies, Emerging and frontier financial markets, Financial institutions, Financial markets, Hedge funds, Money, Prices, Securities markets
• Keywords: Asset prices, asset volatility, Currencies, Emerging and frontier financial markets, emerging market, emerging market asset, Financial Crises, fund manager, Global, Global Linkages, Hedge funds, Index Investors, investor base, market asset return, market assets, optimal portfolio, Securities markets, WP

Content in this bundle

• _wp04199 — Dedicated Investor Demand Space
  • _wp04199 — Dedicated Investor Demand Space (Markdown version)
  • _wp04199 — Dedicated Investor Demand Space (PDF)