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Financial Fragility and Incentives

Abstract

We start from a dynamic general equilibrium model, where agency frictions arising from delegated portfolio management constrain the level of capital. Such frictions can destabilize financial markets, driving up risk premia and volatility, when the level of capital falls. We evaluate how changing fund manager incentives via a relative performance fee impacts financial market stability. The relative performance fee reduces managerial risk-taking, loosening the capital constraint. Asset prices become less sensitive to adverse shocks, reducing risk premia and volatilities, thereby increasing financial stability.

To download the PDF version of the working paper click here.


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