Riding the Bubble with Convex Incentives

Juan Sotes-Paladino and Fernando Zapatero

The Review of Financial Studies, 2019, vol. 32, issue 4, 1416-1456

Abstract: 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.Received July 2, 2016; editorial decision April 28, 2018 by Editor Stijn Van Nieuwerburgh. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Date: 2019
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