Dynamic Asset Allocation with Hidden Volatility

Felix Feng , Mark Westerfield - 2018

We study a dynamic continuous-time principal-agent model with endogenous cash-flow volatility. The principal supplies the agent with capital for investment, but the agent can misallocate capital for private benefit and has private control over both the volatility of the project and the size of the investment. Depending on the curvature of the returns function, the optimal contract can yield either overly-risky or overly-prudent project selection; it can be implemented as a time-varying cost of capital in the form of a hurdle rate. Our model captures stylized facts about the use of hurdle rates in capital budgeting, particularly a small or zero price of volatility, and it helps reconcile mixed empirical evidence on risk choice and managerial compensation.

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