Riding the bubble with convex incentives

Juan Sotes-Paladino, Fernando Zapatero

Research output: Contribution to journalArticlepeer-review

1 Scopus citations

Abstract

Published by Oxford University Press on behalf of The Society for Financial Studies. We show that benchmark-linked convex incentives can lead risk-averse money managers aware of mispricing to overinvest in overpriced securities. In the model, the managers' risk-seeking behavior varies in response to the interaction of mispricing with convexity and benchmarking concerns. Convexity effects can exacerbate the manager's overinvestment in overvalued nonbenchmark securities. In contrast, they potentially offset the benchmarking effects studied in the literature, leading to underinvestment in overpriced benchmark securities. Under correlated mispricing across assets, our model rationalizes positive positions in nonbenchmark, negative risk premium (i.e., “bubble”) securities and “pairs trading” in two overvalued securities. Our findings help explain several empirical puzzles.
Original languageAmerican English
Pages (from-to)1416-1456
Number of pages41
JournalReview of Financial Studies
Volume32
Issue number4
DOIs
StatePublished - 1 Jan 2019
Externally publishedYes

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