Tail Risk, Asset Pricing Effects, and Asymmetric Managerial Incentives

This project is motivated by two different strands of the finance literature.


Tail Risk, Asset Pricing Effects, and Asymmetric Managerial Incentives

Project description

First, the body of the asset pricing literature that focuses on the relation between tail risk and its impact on security prices. This part of the literature suggests that securities with high susceptibility to tail risk are discounted more heavily by investors, which, in equilibrium, leads to greater expected returns. Second, the literature on managerial incentives which suggests that the asymmetric managerial compensation schemes in the fund management industry, whether because of incentive contracts with option-like payoffs, or because of the tournament nature of the fund market and the asymmetric response of investor flows to fund performance, provides strong incentives to fund managers to alter the susceptibility of the portfolios they manage to risk. 

The objectives of this project are two-fold: 

  1. The UK pension fund industry is facing an unprecedented demographic challenge which in an economy with low yields has led to underfunding pressures for most of the pension schemes. Unsurprisingly, the increasing underfunding pressure faced by the UK pension schemes have put pension funds under substantial pressure to achieve and maintain a high level of return in order for pension schemes to be able to provide the promised benefits to pensioners. Our objective is to examine whether pension fund managers alter their susceptibility of the portfolios they manage to tail risk, as a response to the increasing underfunding pressures they face.
  2. Hedge funds frequently use short selling, leverage, and derivatives, strategies that may enhance their performance during volatile markets, but they may also generate significant tail risk. Further, the compensation schemes of most hedge funds have call option-like payoffs (i.e., high-water marks, hurdle rates, performance fees) that may provide strong incentives to fund managers to increase significantly the risk of their portfolios in order to maximize their expected compensation. Our objectives are to examine, (i) whether tail risk helps to explain the time-series and cross-sectional variation in equity-oriented hedge fund returns? and (ii) whether hedge fund managers alter the tail risk susceptibility of their portfolios as a response to their mid-year performance relative to their peers? 

Key research outputs

  • The Tail Risk Premium and Risk-shifting in the UK Pension Funds (working paper)
  • Asymmetric Managerial Incentives and Tail risk-shifting in Hedge Fund Tournaments (working paper)

Research activity

We aim to publish the results and findings of this project to high quality academic journals, as well as outlets more suitable for policy makers and the broad public.