Tournament incentives and the risk-taking behavior of financial agents

Purpose and goal:

Existing literature on how tournament incentives affect risk taking of fund managers is largely restricted to the effects on return volatility and to the effects produced by upside rewards. Little is known about how tournament incentives affect higher moments of fund returns and the effects when rewards and penalties coexist. To facilitate such an analysis, we provide a game-theoretic framework which allows for asymmetric tail risks and “carrot-and-stick” incentive schemes. We draw various predictions on how different reward/penalty schemes affect managerial risk taking.

Expected results and effects:

Our theoretical analysis deepens our understanding of how a change of a rank-based reward/penalty scheme changes financial managers´ risk-taking incentives. It suggests an asymmetry between the upside reward effects and the downside penalty effects: rewarding multiple top-performing managers, instead of rewarding only the best performer, reduces risk taking, whereas punishing multiple bottom-performing managers, instead of punishing only the very worst performer, may actually increase risk taking.

Approach and implementation:

Our current results are based on a novel game-theoretic framework where we allow for an arbitrary number of competing financial managers, asymmetric tail risks, and “carrot-and-stick” incentive schemes. This framework allows us to make sharp predictions on how a change of the number of competing managers and/or a change of the reward/penalty structure of the incentive scheme affects the variance and skewness of fund returns.