An Asset Pricing Model Based on Compensation Contract

Abstract

There is agency problem when more and more investment decisions are delegated to professional investment managers in modern finance market. Asset pricing theory must address the fact that, in reality, professional investment managers are evaluated relative to a benchmark. The compensation contract of agent may be important determinants of capital market equilibrium. In this paper we divide investors into two separate classes, a risk averse individual investor and a risk averse institutional investor whose performance is benchmarked to an index. We drive an agency asset pricing model and make an empirical analysis using data from the Shanghai Stock Exchange of China. We analyze how the ratio of different investors and how the compensation contract of manager affect the asset price. We show that, in the presence of delegated portfolio management, compensation contract of professional investment manager plays a key role in the determination of the expected return of a risk asset.