Portfolio Insurance Incentive Fee Pricing Model

Abstract

An efficient incentive contract to reduce the principal - agent problem is always an important issue in previous literature. Among earlier studies, Margrabe (1978) presented an incentive contract with exchangeable option pricing model to evaluate the manager's relative performance. But in this model, an increase in the tracking error (the volatility) will lead to an increase in management fee. Hence, this will offer a motivation for manager to discretionarily increase the portfolio risk to pursue a higher management fee and thus cause the serious moral hazard. Kritzman and Rich (1998) extended Margrabe (1978) relative performance model and proposed a multivariate model in which combines the relative performance and an absolute performance to reduce the degree of the principal-agent problem. However Kritzman and Rich (1998) only provided little improvement in reducing moral hazard problem. Therefore, this paper intends to derive a portfolio insurance pricing model for incentive fund management fee, which not only can truly reflect the effort and ability of the fund manager but effectively weaken the moral hazard problem as well. Additionally, in this project we also use numerical simulation method to analyze for the effects of some parametric change on incentive fund management fee and compare the results of this model with those of other prior incentive contract models based on alternative assumption.