VGSF Finance Research Seminar
We study how the agency relationship between investors and asset managers affects equilibrium prices. We begin with a static contracting model, in which the optimal contract bounds managers' portfolio risk regardless of their private information. We embed that model into an equilibrium asset-pricing model with noise traders and overlapping generations of investors and managers. Risk limits generate an inverted risk-return relationship: overvalued assets have high volatility because managers buy them during bull markets to meet risk limits. Because overvalued assets have higher share price and volatility, risk limits are more constraining when trading against overvaluation, biasing the aggregate market upward.
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