Optimal Asset Management Contracts with Hidden Savings

Optimal Asset Management Contracts with Hidden Savings

November 2016Working Paper No. 3429

Revise and Resubmit at Econometrica

We characterize optimal asset management contracts in a classic portfolio-investment setting. When the agent has access to hidden savings, his incentives to misbehave depend on his precautionary saving motive. The contract distorts his access to capital to manipulate his precautionary saving motive and reduce incentives for misbehavior. As a result, implementing the optimal contract requires history-dependent equity and leverage constraints. We extend our results to incorporate market risk, hidden investment, and renegotiation. We provide a sufficient condition for the validity of the first-order approach: if the agent’s precautionary saving motive weakens after bad outcomes, the contract is globally incentive compatible.