Essays on Mathematical Finance

Georgios Vichos

Department of Statistics
London School of Economics and Political Science

This dissertation is submitted for the degree of

Doctor of Philosophy

April 2019
I would like to dedicate this thesis to my loving parents.
 Declaration

I certify that the thesis I have presented for examination for the PhD degree of the London
School of Economics and Political Science is solely my own work other than where I have
clearly indicated that it is the work of others (in which case the extent of any work carried
out jointly by me and any other person is clearly identified in it). The copyright of this thesis
rests with the author. Quotation from it is permitted, provided that full acknowledgement is
made. This thesis may not be reproduced without my prior written consent. I warrant that
this authorisation does not, to the best of my belief, infringe the rights of any third party. I
declare that my thesis consists of less than 100,000 words.
I confirm that Chapter 2 was jointly co-authored with Professor Michail Antrhopelos and
Professor Konstantinos Kardaras and I contributed 33% of this work.
I confirm that Chapter 3 was jointly co-authored with Dimitrios Papadimitriou and
Konstantinos Tokis and I contributed 33% of this work.

Georgios Vichos
April 2019
 Acknowledgements

I would like to thank my advisor Konstantinos Kardaras for his support and help, both
scientifically and morally during my academic trip.
I would also like to thank Dimitris Papadimitriou, Konstantinos Tokis, Emmanouil
Androulakis, Dimitris Chatzakos, Nick Savvidis, Diego Zabaljauregui, Stavros Kevopoulos
and Ian Marshall for helpful comments, discussions and encouragement.
I would also like to thank Konstantinos Kalogeropoulos, Beatrice Acciaio, Michail
Anthropelos, Dimitri Vayanos, Johannes Ruf, Jonathan Berk, Amil Dasgupta, Peter Kondor
and Dong Lou, for discussions that inspired this thesis.
This thesis would not have being possible without the generous financial support of the
EPSRC and Philip Treleaven.
Most importantly I devoutly would like to thank Pafuni for her unconditional love, support
and care throughout the volatile PhD journey.
 Abstract

The first part of this thesis deals with the consideration of thin incomplete financial markets,
where traders with heterogeneous preferences and risk exposures have motive to behave
strategically regarding the demand schedules they submit, thereby impacting prices and
allocations. We argue that traders relatively more exposed to market risk tend to submit more
elastic demand functions. Noncompetitive equilibrium prices and allocations result as an
outcome of a game among traders. General sufficient conditions for existence and uniqueness
of such equilibrium are provided, with an extensive analysis of two-trader transactions. Even
though strategic behaviour causes inefficient social allocations, traders with sufficiently high
risk tolerance and/or large initial exposure to market risk obtain more utility gain in the
noncompetitive equilibrium, when compared to the competitive one.
The second part of this thesis considers a continuum of potential investors allocating
funds in two consecutive periods between a manager and a market index. The manager’s
alpha, defined as her ability to generate idiosyncratic returns, is her private information and
is either high or low. In each period, the manager receives a private signal on the potential
performance of her alpha, and she also obtains some public news on the market’s condition.
The investors observe her decision to either follow a market neutral strategy, or an index
tracking one. It is shown that the latter always results in a loss of reputation, which is also
reflected on the fund’s flows. This loss is smaller in bull markets, when investors expect more
managers to use high beta strategies. As a result, a manager’s performance in bull markets is
less informative about her ability than in bear markets, because a high beta strategy does not
rely on it. We empirically verify that flows of funds that follow high beta strategies are less
responsive to the fund’s performance than those that follow market neutral strategies.
Contents

List of Tables viii

1 Introduction 1
1.1 Thesis outline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Major contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2 Effective Risk Aversion In Thin Risk-Sharing Markets 7

2.1 Model Set-Up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.1.1 Agents and preferences . . . . . . . . . . . . . . . . . . . . . . . . 14
2.1.2 Securities and demand . . . . . . . . . . . . . . . . . . . . . . . . 15
2.1.3 Competitive equilibrium . . . . . . . . . . . . . . . . . . . . . . . 16
2.2 Traders’ Best Response Problem . . . . . . . . . . . . . . . . . . . . . . . 19
2.2.1 The setting of trader’s response problem . . . . . . . . . . . . . . . 19
2.3 Noncompetitive Risk-Sharing Equilibrium . . . . . . . . . . . . . . . . . . 23
2.3.1 Nash equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
2.3.2 Equilibrium with at most one trader’s beta being greater than one . 25
2.3.3 Risk-neutral behaved trader(s) . . . . . . . . . . . . . . . . . . . . 26
2.4 Bilateral Strategic Risk Sharing . . . . . . . . . . . . . . . . . . . . . . . . 28
2.4.1 The case of essentially two strategic traders . . . . . . . . . . . . . 28
2.4.2 The effect of incompleteness in thin markets . . . . . . . . . . . . 32

3 The Effect of Market Conditions and Career Concerns in the Fund Industry 35
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
3.2 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
3.2.1 Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
3.2.2 Payoffs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
3.2.3 Timing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
3.2.4 Monotonic equilibrium . . . . . . . . . . . . . . . . . . . . . . . . 43
Contents vii

3.3 Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
3.3.1 Investment and AUM in the second period . . . . . . . . . . . . . . 44
3.3.2 Existence and uniqueness of the monotonic equilibrium . . . . . . 45
3.3.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
3.3.4 Discussion on the competition between funds . . . . . . . . . . . . 50
3.4 Empirics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
3.4.1 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
3.4.2 Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . 54
3.5 Extension: Unobservable Investment Decision . . . . . . . . . . . . . . . . 58
3.6 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

Bibliography 62

Appendix A Appendix on chapter 2 68

A.1 Appendix: Omitted Proofs . . . . . . . . . . . . . . . . . . . . . . . . . . 68

Appendix B Appendix on chapter 3 72

B.1 Appendix: Omitted Proofs . . . . . . . . . . . . . . . . . . . . . . . . . . 72
B.2 Appendix: Investment and AUM in the Second Period . . . . . . . . . . . . 84
B.3 Appendix: Unobservable Investment Decision . . . . . . . . . . . . . . . . 88
List of Tables

3.1 Estimation results : Beta on Market Return. . . . . . . . . . . . . . . . . . 55

3.2 Cross-sectional Regression of Alphas on Betas and controls, t = 12/2015.The
baseline model we run is summarised by alpha ∼ beta + assets + controls. . 55
3.3 Flows on Performance and Beta, t = 12/2015 . . . . . . . . . . . . . . . . 56
3.4 Flows on the interaction of Fund Performance and Market Return . . . . . 57
Chapter 1

Introduction

1.1 Thesis outline

The thesis is organised as follows:

Chapter 1 gives an overview and the contribution of the thesis.

Chapter 2 is about ”Effective risk aversion in risk sharing games”. We consider thin in-
complete financial markets, where traders with heterogeneous preferences and risk exposures
have motive to behave strategically regarding the demand schedules they submit, thereby
impacting prices and allocations. We argue that traders relatively more exposed to market
risk tend to submit more elastic demand functions. Noncompetitive equilibrium prices and
allocations result as an outcome of a game among traders. General sufficient conditions for
existence and uniqueness of such equilibrium are provided, with an extensive analysis of
two-trader transactions. Even though strategic behaviour causes inefficient social allocations,
traders with sufficiently high risk tolerance and/or large initial exposure to market risk obtain
more utility gain in the noncompetitive equilibrium, when compared to the competitive one.

Chapter 3 deals with ”The effect of market conditions and career concerns in the fund
industry”. A continuum of potential investors allocate funds in two consecutive periods
between a manager and a market index. The manager’s alpha, defined as her ability to
generate idiosyncratic returns, is her private information and is either high or low. In each
period, the manager receives a private signal on the potential performance of her alpha, and
she also obtains some public news on the market’s condition. The investors observe her
decision to either follow a market neutral strategy, or an index tracking one. It is shown that
the latter always results in a loss of reputation, which is also reflected on the fund’s flows.
1.1 Thesis outline 2

This loss is smaller in bull markets, when investors expect more managers to use high beta
strategies. As a result, a manager’s performance in bull markets is less informative about her
ability than in bear markets, because a high beta strategy does not rely on it. We empirically
verify that flows of funds that follow high beta strategies are less responsive to the fund’s
performance than those that follow market neutral strategies.
1.2 Major contributions 3

1.2 Major contributions

The purpose of this thesis is to contribute to two topics in financial mathematics. Firstly, a
risk sharing game is studied in a possibly incomplete thin financial market, where investors
strategically declare risk tolerances—not necessarily reflecting their risky profile—in order
to share their risk exposures by means of trading. Secondly, it proposes an equilibrium model
to facilitate how market conditions and concerns of fund managers about their reputation,
impact the fund industry and consequently empirically validates some of the theoretical
findings in this framework. More specifically:

• The domination of many financial markets by a small number of large investors and
the influence of price and allocation of tradeable assets has been widely recognised;
see among others, Blume and Keim (2012), Gibson et al. (2003), Rostek and Weretka
(2015). This type of market impact has been observed in large exchanges like NYSE
(see Keim and Madhavan (1995, 1996), Madhavan and Cheng (1997), Hameed et al.
(2017)), especially in over the counter transactions that the assumption of a competitive
market structure cannot hold. In reality the majority of these types of transactions
involve a few participants and although all the information is public, equilibrium forms
in a game-theoretic manner.
Chapter 2’s purpose is to model imperfect competition between traders by assuming
that they submit linear net demand functions with a slope that might be different from
their competitive demand function. The random endowments of the investors and the
terminal dividends of the traded securities are assumed to be Gaussian. The slope
of the trader’s demand function depends on their risk tolerance. When these risk
tolerances are considered public information, explicit formulas for the competitive
equilibrium allocations and the prices of securities can be obtained. While the agents’
risk exposures may be public information, their risk aversion can be regarded as private
information. Motivated by these observations, the chapter studies noncompetitive
equilibrium problem arising when investors act strategically by submitting demand
functions with an elasticity that does not necessarily reflect their risk aversion. In this
risk sharing game, the study provides explicit formulas for the best response functions
in terms of the traders’ pre transaction projected betas on risk exposures. These
formulas are then used to prove the existence and uniqueness of the Nash equilibrium.
More precisely, extreme noncompetitive equilibria when an agent acts as risk neutral
are completely characterised. Additionally, if at most one agent is highly exposed to
market risk, then a Nash equilibrium exists and is unique. In the bilateral (two-agent)
risk sharing game, explicit formulas for the noncompetitive equilibrium are given.
1.2 Major contributions 4

These formulas facilitate the analysis of individual and aggregate utility gains and
losses, as well as risk sharing inefficiencies, when compared to the outcome under the
competitive equilibrium setup or a complete market. One of the main conclusions of
the analysis is that, even though aggregate utility decreases, investors with sufficiently
high risk exposures or sufficient high risk tolerance might benefit from the game. These
gains are reduced by the incompleteness of the market. Furthermore, the game leads to
risk sharing inefficiencies as the post transaction betas are higher than those obtained
in the competitive set up.

• The concern of the role of financial intermediaries such as hedge funds and mutual finds
has been growing alongside the proportion of the institutional ownership of equities.
The competition of the managers and their concern about their reputation may influence
their investment decisions in a way that is not necessarily optimal. One of the seminal
papers about mutual funds is Berk and Green (2004), where the lack of persistence
of outperformance is explained by the competition between funds and reallocation of
investors’ capital and not by the lack of managers’ skills. The connection of reputation
and investment decisions has been recently studied and one can remark the following:
risk taking behaviour in order to increase manager’s reputation leads to overinvestment
(Chen (2015)), and reputation concerns lead to herding and some other anomalies
and career concerns create a reputational premium which depends on the economic
conditions (Dasgupta and Prat (2008)). Moreover, Malliaris and Yan (2015) show
that career concerns induce a preference over the skewness of their strategy returns,
while Hu et al. (2011) present a model of fund industry in which managers alter their
risk-taking behaviour based on their past performance; however, they do not take into
account any strategic behaviour by the fund managers.
Chapter 3 is motivated by the interaction between concerns about reputation and
investment decisions of fund managers. The study proposes a two period equilibrium
model where the manager’s investment decisions provide imperfect information about
their managing abilities. More precisely, investors receive initially a shock that will
determine their wealth allocation for the first period. After the investors’ decision,
the manager receives a private signal on her idiosyncratic strategy and a public signal
on market conditions. She then decides whether to invest in the market or in her
idiosyncratic strategy. After observing the returns and the actions of the manager in
the first period, investors update their beliefs about the ability of the manager. Based
on this Bayesian update of reputation, they allocate their wealth for the second and
final period. In this set up, it is clear that the manager’s actions are influenced by the
consequences that they could have on her reputation after the first period, and hence on
1.2 Major contributions 5

the assets that she will have under management on the second period. The analysis then
focuses on monotonic equilibrium, these are equilibria where the manager’s reputation
is a nondecreasing function of her performance.

– As a first result, a refinement of the perfect Bayesian Equilibrium is analysed,

which is called monotonic equilibrium, and it is shown that this always exists. The
only additional restriction that this refinement is imposing is that the manager’s
reputation is non-decreasing on her performance. In addition, under mild para-
metric restrictions it is demonstrated that the monotonic equilibrium is unique.
– As a second result, it is demonstrated that investing in an idiosyncratic strategy
carries a reputational benefit. This is because the cut-off of the high manager
type is smaller than that of the low manager types. In other words, the high
type is more receptive to the idea of adopting a low beta strategy. Intuitively,
the manager’s choice is affected by two incentives. On the one hand, she wants
to increase her reputation, which skews her preferences towards idiosyncratic
investments. On the other hand, she cares about the realised return of her strategy,
since her fees depend on it. Hence, for a relatively low private signal, even a high
type may opt to forfeit the reputational benefit, because investing in the market
will generate higher returns, and as a result more fees. Therefore, the investment
strategy is informative but does not fully reveal the manager’s ability, which is a
realistic representation of the fund industry.
– Finally, as the third and most important result, it is shown that the reputational
benefit of investing in the idiosyncratic project is decreasing in the market con-
ditions. In particular, it is proven that the expected sensitivity of reputation to
performance is higher in bear markets than in bull markets. This is because
investors understand the dual objective of managers and the fact that a manager
is more likely to invest in the market when the market conditions are good, and
thus update their beliefs less aggressively when this is the case; instead, in bad
times any change in a fund’s performance is much more likely to be attributed to
the ability of the manager.
– The above results are used to discuss the competition between funds, in terms
of their sizes, and its fluctuation depending on market conditions. It is predicted
that the likelihood of changes in the ranking of the funds, measured by assets
under management, is hump-shaped on the market return, but is also higher
during bear markets than during bull markets, due to the higher informativeness
of performance. Some empirical evidence is found that supports this prediction.
1.2 Major contributions 6

This is in line with the common perception that the industry only rearranges its
interaction with its investors during crises.

Some of the assumptions and findings from the theoretical model are confirmed by an
empirical analysis using data from the Morningstar CISDM. At the end of the chapter
it is shown that it is impossible to find monotonic equilibria if the betas of the managers
are unobservable.
Chapter 2

Effective Risk Aversion In Thin

Risk-Sharing Markets

Introduction
It has been widely recognised that many financial markets are dominated by a relatively small
number of large investors, whose actions heavily influence prices and allocations of tradeable
securities—see, among others, discussions in Blume and Keim (2012), Gibson et al. (2003),
Rostek and Weretka (2015). While such market impact has been observed even in large
exchanges like NYSE (see Keim and Madhavan (1995, 1996), Madhavan and Cheng (1997)
and the more recent empirical study Hameed et al. (2017)), it is especially in over-the-counter
(OTC) transactions that the assumption of a competitive market structure is problematic. The
majority of OTC markets involve relatively few participants; therefore, even if all information
is public, equilibrium forms in a noncompetitive manner. Such financial markets with an
oligopolistic structure are usually characterised as thin (see Rostek and Weretka (2008) for a
related reviewing discussion).
The main reason for trading between risk averse traders with common information and
beliefs is the heterogeneity of their endowments—see, for instance, related discussion in
Barrieu and El Karoui (2005), Jouini et al. (2008). Trading securities that are correlated with
traders’ endowments may be mutually beneficial in sharing the traders’ risky positions—see,
among others, Anthropelos and Žitković (2010), Robertson (2017). In a standard Walrasian
uniform-price auction model, traders submit demand schedules on the tradeable securities
and the market clears at the prices resulting in zero aggregate submitted demand; and since
demand depends on traders’ characteristics such as their risk exposure and risk aversion, the
same is true for the equilibrium prices and allocation. Whereas traders’ exposures to market
 8

risk (i.e., uncertainty in the tradeable securities) may be considered public knowledge, their
risk aversion is subjective and should be regarded as private information. In the realm of thin
financial markets, traders may have motive to act strategically and submit demand schedules
with different elasticity than the one reflecting their risk aversion. The goal of this paper is to
model such strategic behaviour and highlight some of its economic insights.

Model description and main contributions

We develop a model of a one-shot transaction on a given collection of risky tradeable
securities, under common information on the probabilistic nature of their payoffs. Traders
possess and exploit a potential to impact the market’s equilibrium. We adopt the setting of
CARA preferences and normally distributed payoffs, also appearing in Kyle (1989), Rostek
and Weretka (2015), Vayanos (1999), with traders assumed heterogeneous with respect to risk
tolerance (defined as the reciprocal of risk aversion) and initial risky positions. In contrast to
the majority of related literature, we do not assume that traders’ endowments belong to the
span of the tradeable securities, leading to market incompleteness.
Similarly to the models in Kyle (1989), Vayanos (1999), Vives (2011), the market operates
as a uniform-price auction where traders submit demand functions on the tradeable securities,
with equilibrium occurring at the price vector that clears the market. When traders do not
act strategically, the market structure is competitive and the equilibrium price-allocation is
induced by traders’ true demand functions. However, as has been pointed out previously, such
competitive structure is not suitable for thin markets, and the way traders behave depends on
principle on the risk exposure and risk tolerance of their counter-parties. In a CARA-normal
setting, demand functions are linear with a downward slope and their elasticities coincide
with the traders’ risk tolerance. Traders recognise their ability to influence the equilibrium
transaction, and may submit demand with different elasticity than the one reflecting their risk
tolerance. We formulate a best-response problem, according to which traders submit demand
functions aiming at individual utility maximisation, with strategic choices parametrised by
the elasticity of the submitted demand. This forms a noncompetitive market scheme, where
the Bayesian Nash equilibrium is the fixed point of traders’ best responses.
In any non-trivial case, traders have motive to submit demand with different elasticity
than their risk tolerance. The main determining factor of traders’ best response is their pre-
transaction projected beta, defined as the beta (in terms of the Capital Asset Pricing Model)
of the projection of the trader’s risky position onto the linear space generated by the securities.
In the special case where the traders’ positions belong to the span of tradeable securities
projected and actual betas coincide. Following classical literature, traders’ projected betas
 9

(hereafter simply called betas) measure their exposure to market risk. In terms of risk sharing,
we distinguish traders to those who increase or decrease their beta through the transaction.
It is shown that traders submit demand corresponding to higher risk tolerance if and
only if they reduce their market risk exposure through trading. The economic insight of
this strategic behaviour is simple: traders with relatively higher initial exposure to market
risk pay a risk premium to their counter-parties in order to reduce their beta. Submitting a
more elastic demand has two main effects. Firstly, the post-transaction reduction of beta is
smaller, since more elastic demand implies higher relative risk tolerance and hence higher
post-transaction exposure to market risk, as the trader appears willing to keep a more risky
position. Secondly, the risk premium that is paid is also lower. As it turns out, the effect of
premium reduction overtakes the sub-optimal reduction of market risk exposure. In order
to obtain intuition on this, consider the impact of the other traders’ status on an individual
trader’s actions. Large pre-transaction beta for a specific trader implies low aggregate beta
for other traders. Acting in a more risk tolerant way, by submitting more elastic demand, a
trader essentially exploits this low aggregate exposure to market risk of the counter-parties,
and in fact decreases the premium that they ask in order to undertake more market risk.
On the contrary, traders who undertake market risk in exchange for a risk premium, i.e.,
those with low pre-transaction beta, have motive to submit less elastic demand. Not only
does such a strategy result in less undertaken market risk, it also takes advantage of the
large aggregate counter-parties’ beta, increasing the premium received in order to offset their
demand.
Continuing this line of argument, traders overexposed to market risk, with pre-transaction
beta sufficiently higher than one, tend to behave as risk neutral, even though their actual
risk aversion parameter is strictly positive. In such a case, the trader takes over the whole
market risk, reducing the post-transaction beta of their position to one. At the same time,
the other traders are willing to offset such transaction since it makes their post-transaction
beta equal to zero (i.e., becoming market-neutral); for this reason, they reduce the required
risk premium. On the other hand, traders with pre-transaction beta less than or equal to −1
submit extremely inelastic demand functions, implying zero risk tolerance, appearing willing
to become market neutral. Again, other traders are eager to offset the transaction, since at
this regime their aggregate pre-transaction beta is relatively large, and selling market risk is a
very effective hedging transaction.
We discover two regimes of noncompetitive equilibrium. When one of the trader’s
pre-transaction beta is sufficiently large, there exists a unique linear equilibrium which is
extreme, in the sense that the market-overexposed trader behaves as being risk neutral and at
equilibrium undertakes all market risk. Such extreme Nash equilibrium results in market-
 10

neutral portfolios for all other traders, while securities are priced in a risk-neutral manner. In
any other “non-extreme” cases, noncompetitive equilibria solve a coupled system of quadratic
equations, which admits a unique solution under the mild—and rather realistic—assumption
that at most one of the traders may have pre-transaction beta greater than one. We provide an
efficient constructive proof of the latter fact, which can be used to numerically obtain the
unique linear equilibrium given an arbitrary number of traders.
The two-trader case is of special interest, mainly because the large majority of risk-
sharing transactions are bilateral between large institutions and/or their clients or brokers;
related discussions and statistics are provided in Babus and Hu (2016), Babus (2016), D.
et al. (2015), Zawadowski (2013), Hendershott and Madhavan (2015). We obtain explicit
expressions for two-trader price-allocation noncompetitive equilibria, which allow us to
further analyse the model’s economic insight. Noncompetitive and competitive equilibria
coincide if and only if the competitive equilibrium transaction is null, in that the initial
allocation is already Pareto-optimal. In any other case, for both traders the elasticity of
submitted demands in such thin markets deviates from the one utilising their risk tolerances.
As emphasised above, the crucial factor is the traders’ pre-transaction beta. For non-extreme
equilibria we have the following synoptic relationship:
true elasticity < equilibrium elasticity ⇔ post-transaction beta < pre-transaction beta.
Even if traders have common risk tolerance, deviations between their endowment will make
them behave heterogeneously. For a trader with higher (resp., lower) beta, who reduces (resp.,
increases) market risk through the transaction, the equilibrium elasticity reflects more (resp.,
less) risk tolerance. One could argue, therefore, that in thin financial markets the assumption
of effectively homogeneous risk-averse traders is problematic, since it essentially implies
that traders ignore their ability to impact the transaction.
In the context of strategic behaviour, equilibrium prices and allocations are generally
impacted. In the two-trader case, the volume in noncompetitive equilibrium is always
lower than in the competitive one. More precisely, it is shown that the post-transaction
beta after Nash equilibrium is—interestingly enough—the midpoint between the trader’s
pre-transaction beta and the beta after the competitive transaction. This implies a loss of
social efficiency, in the sense that the total utility in noncompetitive equilibrium is reduced
when compared to the competitive one. However, such loss of total utility does not always
transfer to the individual level. In fact, it follows from the analysis of the bilateral game
that the noncompetitive equilibrium is beneficial in terms of utility gain for two types of
traders: those with sufficiently high pre-transaction beta, and those with sufficiently high risk
tolerance. Such findings in noncompetitive markets are consistent with results in Anthropelos
(2017) and Anthropelos and Kardaras (2017). (A result in that spirit also appears in Malamud
 11

and Rostek (2017); namely it is shown that, when the market is centralised, less risk averse
agents have greater price impact.)
As a final point, and as mentioned above, our model allows for incompleteness, and we
study its effect in noncompetitive risk-sharing transaction. Based on the two-trader game, we
show that traders who benefit from the noncompetitive market setting (i.e., those with high
risk tolerance and/or high exposure to market risk) have their utility gains reduced by the fact
that endowments are not securitised, highlighting the importance of completeness especially
for large traders that prefer thin markets for sharing risk.

Connections with related literature

The present paper contributes to the large literature on imperfectly competitive financial
markets. Based on the seminal works on Nash equilibrium in supply/demand functions of
Klemperer and Meyer (1989) and Kyle (1989), most models of noncompetitive markets
consider strategically acting agents, whose set of choices corresponds to demand schedules
submitted to the transaction. Frequently, the departure from competitive structure stems from
informational asymmetry; such is the case in Back (1992), Back et al. (2000), Kyle (1989),
Kyle et al. (2018), where agents are categorised as informed, uniformed and noisy. Even
without existing risky positions, asymmetric information gives rise to mutually beneficial
trading opportunities among traders, who submit demand schedules based on the responses of
their counter-parties. Another potential source of noncompetitiveness comes via exogenously
imposing asymmetry on the bargaining power among market participants. Bilateral OTC
transactions between agents with different bargaining power are modelled in Duffie et al.
(2007); in Liu and Wang (2016), it is market makers who possess market power and optimally
adjust bid-ask spreads based on submitted orders by informed and uniformed investors. (See
the references in Liu and Wang (2016) for alternative models of strategic market makers.)
Exogenously imposed differences on market power are also present in Brunnermeier and
Pedersen (2005), where traders are divided into price-takers and predatory ones, the latter
strategically exploiting the liquidity needs of their counter-parties.
In contrast to the above, our model assumes symmetry for traders’ market power; non-
competitiveness stems solely from the fact there is a small number of acting traders, each of
whom can buy or sell the tradeable securities and has the ability to affect the risk-sharing
 12

transaction.1 The market here is assumed to be oligopolistic, without any form of exogenous
frictions or asymmetries.
Market models close to ours considered by other authors include Malamud and Rostek
(2017), Rostek and Weretka (2015), Vayanos (1999). In Malamud and Rostek (2017), Rostek
and Weretka (2015), Vayanos (1999), and similarly to the present work, traders submit
demand in a noncompetitive market setting by taking into account the impact of their orders
on the equilibrium. The main difference with our demand-game, when compared to the
one-shot market of Rostek and Weretka (2015), Vayanos (1999) and the centralised market of
Malamud and Rostek (2017), is the set of traders’ strategic choices. More precisely, in these
works a trader’s price impact is identified as the slope of the submitted aggregate demand
of the rest of the traders. Traders estimate (correctly at equilibrium) their price impact and
respond by submitting demand schedules aiming at maximising their own utility. In particular,
the set of strategic choices consists of the slope of the submitted demand, and equilibrium
arises as the fixed point of the traders’ price impacts. In our model, we keep the linear
equilibrium structure of demand functions and parametrise the set of traders’ strategical
choice to the submitted elasticity, and equilibrium is formed simply at the price where
aggregate submitted demand is zero. In this way, each trader responds to the whole demand
function of other traders, and not just the slope. This is a crucial trading feature motivated by
the benefits of risk sharing, since the intercept point of the demand function corresponds to
the traders’ exposure to market risk (the correlation of traders’ endowment with the tradeable
assets). The difference becomes pronounced in the very special case of a single tradeable
security, where traders’ price impacts of Rostek and Weretka (2015) and Malamud and
Rostek (2017) can be seen as the reciprocal of their risk aversion. In Rostek and Weretka
(2015), the so-called equilibrium effective risk aversion—that is, the risk aversion that is
reflected by the equilibrium submitted demands—depends only on the number of traders (as
well as a couple of other quantities that we do not use in our model: interest rate and number
of allowable trades until the end of each trading round). In particular, heterogeneity of initial
risky endowments is not addressed: even with different initial positions at each period, traders
do not take into account their counter-parties’ exposure to market risk. Our demand-game
1
Symmetric games in an oligopolistic market of goods (rather than securities with stochastic payoffs) have
also been studied in the seminal work of Klemperer and Meyer (1989) and in the more recent papers of Vives
(2011) and Weretka (2011). The main structural difference between these market models and ours is that players
therein (i.e., firms) can take only the seller’s side, while the buyer’s side (i.e., the demand for the goods) is
essentially exogenous. Additionally, the fact that the tradeable asset is a good creates further technical and
economic deviations—for instance, the role of risk exposure is essentially played by the cost function, the price
can not be negative, etc. The model in Klemperer and Meyer (1989) imposes randomness on demand, whereas
Vives (2011) considers random suppliers’ cost and private information status. On the other hand, the model of
market power in Weretka (2011) is based on the same setting of price impact as in Rostek and Weretka (2015)
and Malamud and Rostek (2017).
 13

may be more appropriate for thin risk-sharing transactions, since it endogenously highlights
the importance of traders’ initial positions for their strategic behaviour.
Another important trait of our model is that it can be applied to the practically important
two-trader case, while the models of Rostek and Weretka (2015), Malamud and Rostek (2017)
and Vayanos (1999) are ill-posed for bilateral transactions. As already mentioned, bilateral
transactions are a significant part of thin market models, since the majority of the OTC risk-
sharing transactions consist of only two counter-parties. Existence of a two-agent Bayesian
Nash equilibrium exists under mild assumptions in the model of Rostek and Weretka (2012);
however, agents there have private valuations on the tradeable securities.
Further to what was pointed out above, our model allows market incompleteness: trade-
able securities do not necessarily span the traders’ endowments. We are thus able to generalise
the discussion on thin markets and deviations of noncompetitive equilibria from competitive
ones in the more realistic framework where traders’ endowments are neither securitised nor
replicable.
Finally, models of thin risk-sharing markets, albeit with a different set of strategic choices,
have been considered in Anthropelos (2017) and Anthropelos and Kardaras (2017). In
Anthropelos (2017), traders choose the endowment submitted for sharing, and a game on
agents’ linear demand is formed; in contrast with the present paper, agents in Anthropelos
(2017) choose the intercept of the demand function instead of its elasticity. In Anthropelos
and Kardaras (2017), traders strategically submit probabilistic beliefs, and the model is
“inefficiently complete”, as securities are endogenously designed by heterogeneous traders in
order to share their risky endowments.

Structure of the paper

Section 2.1 introduces the market model and competitive equilibrium, where traders do
not act strategically. Section 2.2 introduces, solves and discusses the individual trader’s
best response problem. Noncompetitive equilibrium is introduced in Section 2.3; general
conditions ensuring existence and uniqueness of Nash equilibrium are provided in §2.3.2,
conditions for the so-called extreme equilibrium are addressed in §2.3.3. The two-trader game
is extensively analysed in Section 2.4. The proof of the main Theorem 2.3.4 is presented in
Appendix A.1.
2.1 Model Set-Up 14

2.1 Model Set-Up

We work on a probability space (Ω, F , P), and denote by L0 ≡ L0 (Ω, F , P) the class F -
measurable random variables, identified modulo P-a.s. equality.

2.1.1 Agents and preferences

We consider a market of n + 1 economic traders, where n ∈ N = {1, 2, . . .}; for concreteness,
define the index set I = {0, . . . , n}. Traders are assumed risk averse and derive utility only
from future consumption of a numéraire at the end of a single period, where all uncertainty
is resolved. To simplify the analysis we assume that all considered security payoffs are
expressed in units of the numéraire, which implies that future deterministic amounts have the
same present value for the traders. Each trader i ∈ I carries a risky future payoff in units of
the numéraire, which is called (random) endowment, and denoted by Ei . The endowment
Ei ∈ L0 denotes the existing risky portfolio of trader i ∈ I, and is not necessarily securitised
P
or tradeable. We define the aggregate endowment E I := i∈I Ei , and set E ≡ (Ei )i∈I to be the
vector of traders’ endowments.
The preference structure of traders is numerically represented by the functionals

L0 ∋ X 7→ Ui (X) := −δi log E exp (−X/δi ) ∈ [−∞, ∞),

 
(2.1)

where δi ∈ (0, ∞) is the risk tolerance of trader i ∈ I. Note that Ui (X) corresponds to
the certainty equivalent of potential future random outcome X, when trader i ∈ I has risk
preferences with constant absolute risk aversion (CARA) equal to 1/δi . It is important to
point out that functional Ui (·) also measures wealth in numéraire units and hence can be
used for comparison among different traders (and equilibria). We also define the aggregate
risk tolerance δI := i∈I δi , as well as the relative risk tolerance λi := δi /δI of trader i ∈ I.
P

Note that λI ≡ i∈I λi = 1. Following standard practice, we shall use subscript “−i” to
P

denote aggregate quantities of all traders except trader i ∈ I; for example, δ−i := δI − δi and
λ−i := 1 − λi , for all i ∈ I.
2.1 Model Set-Up 15

2.1.2 Securities and demand

In the market there exist a finite number of tradeable securities indexed by the non-empty set
K, with payoffs denoted by S ≡ (S k )k∈K ∈ (L0 )K . The demand function Qi of trader i ∈ I on
the vector S of securities is given by

Qi (p) := argmax Ui (Ei + ⟨q, S − p⟩), p ∈ RK .

q∈RK

Here, and in the sequel, ⟨·, ·⟩ will denote standard inner product on the Euclidean space RK .
We follow a classic model of standard literature (e.g. Kyle (1989), Rostek and Weretka
(2015), Vayanos (1999) and Vives (2011)) and assume that the joint law of (E, S ) is Gaus-
sian. Since traders’ endowments do not necessarily belong to the span of S , the market is
incomplete. Note also that endowments are not assumed independent of S , or independent of
each other. Since only securities in random vector S are tradeable, we identify market risk
with the variance-covariance matrix of S , denoted by

C := Cov(S , S ).

In the sequel we will impose the standing assumption that C has full rank. Additionally, for
notational convenience, we shall assume that

E[S k ] = 0, ∀k ∈ K.

Due to the cash-invariance of the traders’ certainty equivalent, the latter assumption does
not entail any loss of generality, as we can normalise tradeable securities to be S − E[S ].
Straightforward computations give

Ui (Ei + ⟨q, S − p⟩) = −δi log E exp (−(Ei + ⟨q, S − p⟩)/δi )

 

1
= E [Ei ] − ⟨q, p⟩ − Var Ei + ⟨q, S ⟩
 
2δi
* +
1 1 1
= E [Ei ] − Var [Ei ] − ⟨q, Cq⟩ − q, p + Cov(Ei , S ) .
2δi 2δi δi

We also define the following quantities

1
ui := E [Ei ] − Var [Ei ] ≡ Ui (Ei ),
2δi
2.1 Model Set-Up 16

and, for each i ∈ I,

ai := C −1 Cov(Ei , S ), and a−i := aI − ai ,

where X
aI := ai .
i∈I

Then, it follows that

1 1
Ui (Ei + ⟨q, S − p⟩) = ui − ⟨q, Cai ⟩ − ⟨q, Cq⟩ − ⟨p, q⟩ ,
δi 2δi

from which we readily obtain that the demand function of trader i ∈ I, given by

RK ∋ p 7→ Qi (p) = −ai − δiC −1 p, i ∈ I, (2.2)

is downward-sloping linear. The risk tolerance δi ∈ (0, ∞) could be considered as the

elasticity of the demand function of trader i ∈ I, with higher δi implying more elastic demand.
Furthermore, ai ∈ RK gives the correlation of the tradeable securities with the endowment
of trader i ∈ I, and plays the role of the intercept point of the affine demand function (2.2).
According to (2.2), when prices of all securities equal zero, the sign of each element of ai
indicates whether trader i ∈ I has incentive to buy (when negative) or sell (when positive) the
corresponding security.

2.1.3 Competitive equilibrium

While our focus will be on noncompetitive equilibrium, we first define competitive equilib-
rium of our market, to be used and discussed later as a benchmark for comparison, similarly
as in Vayanos (1999) and Vives (2011). Trading the securities represented by S without
applying any strategic behaviour (i.e., by assuming a price-taking mechanism), the traders
reach a competitive equilibrium: prices are determined where the traders’ aggregate demand
equals zero.

p ∈ RK is called competitive equilibrium prices if

Definition 2.1.1 The vector b
X
p) = 0.
Qi (b
i∈I

The corresponding allocation (b qi = Qi (b

qi )i∈I ∈ RK×I defined via b p) for all i ∈ I will be called
a competitive equilibrium allocation associated to (competitive equilibrium) prices b p ∈ RK .

Elementary algebra gives the following result.

2.1 Model Set-Up 17

Proposition 2.1.2 There exists a unique competitive equilibrium price b

p given by

1
p = − CaI , (2.3)
δI
b

with associated competitive equilibrium allocations given by

qi = λi aI − ai ,
b i ∈ I. (2.4)

Remark 2.1.3 For i ∈ I, Di := ⟨ai , S ⟩ is the projection of the endowment Ei onto the linear
span of the tradeable security vector S ≡ (S k )k∈K . At competitive equilibrium, the position of
trader i ∈ I, net the price paid, is

1
qi , S − b
p = ⟨λi aI − ai , S ⟩ + ⟨λi aI − ai , CaI ⟩ = λi DI − Di − EQ [λi DI − Di ] , i ∈ I.
δI
b

where Q is given through dQ/dP = exp(−E I /δI )/EP exp(−E I /δI ) , where DI := i∈I Di . In
  P

the case where the linear span of the securities equals the linear span of the endowments,
it holds that Di = Ei − EP [Ei ], for all i ∈ I. Then, the competitive equilibrium coincides
with the complete-market Arrow-Debreu risk-sharing equilibrium—see, among others, Borch
(1962), Buhlmann (1984) or (Magill and Quinzii, 2002, Chapters 2 and 3).

Remark 2.1.4 A very special—and as shall be discussed, trivial—situation arises when

aI = 0, i.e., when Cov(E I , S k ) = 0 holds for every k ∈ K, where we recall that E I := i∈I Ei .
P

In words, aI = 0 means that the total endowment E I is independent of the spanned subspace
of the securities. In this case, in the setting of Proposition 2.1.2, competitive equilibrium
prices of the securities are zero, and b qi = −ai . It follows that, in competitive equilibrium,
traders simply rid themselves of the hedgeable part of their endowment at zero prices, and
end up after the transaction with the part that is independent of the securities. (In this respect,
recall the previous Remark 2.1.3.)

Given that the case aI = 0 is covered by Remark 2.1.4 above, we shall assume tacitly in
the sequel that aI , 0. (The only point where we return to the case aI = 0 is at Remarks
2.2.1 and 2.3.2.) When aI , 0, we define the following parameters, which will turn out to be
crucial for our analysis:

Cov(E I , S )C −1 Cov(Ei , S ) ⟨aI , Cai ⟩

βi := = , i ∈ I. (2.5)
Cov(E I , S )C −1 Cov(E I , S ) ⟨aI , CaI ⟩

Note that X
βI ≡ βi = 1.
i∈I
2.1 Model Set-Up 18

When the traders’ endowments are tradeable, i.e., when the endowment vector Ei belongs
in the linear span of (S k )k∈K for all i ∈ I, then βi literally coincides with the beta of the ith
endowment, in the terminology of the Capital Asset Pricing Model. In general, βi should be
considered as a “projected beta” of the ith endowment onto the space of tradeable securities;
as stated in the introduction, it shall be called simply (pre-transaction) beta in the sequel.
Consistent with classical theory, betas shall measure the level of exposure to market risk of
each trader before and after the equilibrium transaction.
Both equilibrium prices and allocations strongly depend on the traders’ heterogeneity.
After the competitive transaction, the position of trader i ∈ I is Ei + b qi , S − b
p , and one may
immediately calculate the post-transaction beta of the position to be equal to λi . Hence, at
competitive risk sharing, each trader ends up with a positive exposure to market risk, with
a beta less than one, even if initial positions are negatively correlated to market risk. Note
also that traders with higher risk tolerance are willing to get relatively more exposure to the
market risk through the competitive transaction.
The cash amount (signed risk premium) that trader i ∈ I pays to obtain post-transaction
beta equal to λi is
qi , b
b p = (βi − λi ) ⟨aI , CaI ⟩ /δI ,

which is linearly increasing with respect to βi . In fact, traders that reduce their beta after
the competitive transaction (i.e., those with λi < βi ) pay a positive risk premium b qi , b
p =
qi , b
b p to their counter-parties. On the other hand, traders that undertake market risk at
the competitive transaction (i.e., those with βi < λi ) are compensated with a risk premium
qi , b
b p =− b qi , b
p .
Based on the formulas of equilibrium prices and allocations of (2.3) and (2.4), we readily
calculate and decompose the traders’ utility at competitive equilibrium as

1 2 1 2
Ui Ei + b
qi , S − b
p = ui + C 1/2 (λi aI − ai ) = ui + C 1/2b


qi (2.6)
2δi 2δi
1 ⟨aI , CaI ⟩ βi − λi
= ui + ⟨ai , Cai ⟩ − λ2i − ⟨aI , CaI ⟩, i ∈ I.
2δi
| {z 2δi } | δ I
{z }
profit/loss from random payoff (signed) risk premium

Larger trades at competitive equilibrium result in higher utility gain after the transaction. The
above decomposition of utility into risk-sharing gain and risk premium allows one to further
analyse the exact sources of utility for each trader, and will prove especially useful later on,
when comparing competitive and noncompetitive equilibria.
2.2 Traders’ Best Response Problem 19

2.2 Traders’ Best Response Problem

2.2.1 The setting of trader’s response problem
While it is rather reasonable to assume that pre-transaction betas are publicly known, it
is problematic to impose a similar informational assumption on traders’ risk profiles. We
view risk tolerance as a subjective parameter, and more realistically consider it as private
information of each individual trader. In the CARA-normal market setting treated here, each
trader’s risk tolerance is reflected in the elasticity of the submitted demand function. In
particular, from Proposition 2.1.2 and the induced individual utility gain (2.6), elasticities of
traders’ submitted demand directly affect both the allocation of market risk and the associated
risk premia. Therefore, it is reasonable to inquire whether an individual trader has motive to
strategically choose the elasticity of the submitted demand function. More precisely, adapting
the family of linear demand functions with downward slope of the form (2.2), strategically
chosen elasticity is equivalent to submitting demand function

Qθi i (p) = −ai − θiC −1 p, p ∈ RK , (2.7)

where θi ∈ (0, ∞) is the elasticity of the submitted demand function Qθi i ; equivalently, 1/θi
is the risk aversion reflected by the submitted demand. In the extreme case where θi → ∞,
trader i ∈ I submits extremely elastic demand, or equivalently behaves as risk neutral, while
θi → 0 indicates extremely inelastic demand, i.e., a case where the trader does not want to
undertake any risk.
The question addressed in the present section is how traders choose the elasticity of
their demand function within the family of demands (2.7), and whether this is different than
their risk tolerance. In order to make headway with examining the best response function of
trader i ∈ I, we assume that all traders except trader i ∈ I have submitted an aggregate linear
demand function of the form (2.7), where θ−i = j∈I\{i} θ j ∈ (0, ∞) is the aggregate elasticity
P

of all traders except trader i ∈ I. Under this scenario, if trader i ∈ I chooses to submit the
demand function (2.7) with θi ∈ (0, ∞), and recalling (2.3) and (2.4), the equilibrium price
and allocations will equal

1 θi
p(θi ; θ−i ) = − CaI , qi (θi ; θ−i ) = aI − ai ,
θi + θ−i θi + θ−i
b b

and hence the trader’s payoff will equal

Ei + b
qi (θi ; θ−i ), S − b
p(θi ; θ−i ) .
2.2 Traders’ Best Response Problem 20

Since θ−i > 0, the limiting cases when θi = 0 (interpreted as extreme inelasticity) and θi = ∞
(interpreted as risk neutrality) are well defined; indeed, taking limits in the expressions above,
it follows that
1
p(0; θ−i ) = − CaI , qi (0; θ−i ) = −ai ,
θ−i
b b

p(∞; θ−i ) = 0,
b qi (∞; θ−i ) = aI − ai = a−i .
b

Risk-neutral acting traders satisfy all the demand of the other traders, accepting all their
market risk, without asking a risk premium (recall that we have assumed that E[S k ] = 0, ∀k ∈
K). On the other hand, extremely inelastic demand implies hedging all the initial positions,
making the post-transaction beta equal to zero and in fact delegating determination of
equilibrium prices to other traders. Using the standard terminology of portfolio management,
we call market-neutral a position with zero beta.
For θ−i ∈ (0, ∞), and under the standing assumption of Gaussian endowments and
securities made in Section 2.1, the response function of trader i ∈ I is

(0, ∞) ∋ θi 7→ Vi (θi ; θ−i ) ≡ Ui (Ei + b qi (θi ; θ−i ), S − bp(θi ; θ−i ) )

θi θi
* !!+
1 1
ui + a I − ai , C aI − aI + ai ,
θi + θ−i θi + θ−i 2δi θi + θ−i

with θi indicating parametrisation of the trader’s strategic behaviour. Since the limiting
cases for θi are also well defined, we allow a trader to submit demand functions that declare
extreme and zero elasticity; for these cases, we have
!
1 1 1
Vi (0; θ−i ) = Ui Ei − ⟨ai , S ⟩ − ⟨ai , CaI ⟩ = ui + ⟨ai , Cai ⟩ − ⟨ai , CaI ⟩ ,
θ−i 2δi θ−i
1
Vi (∞; θ−i ) = Ui (Ei + ⟨a−i , S ⟩) = ui − ⟨a−i , C(aI + ai )⟩ .
2δi

Summing up, given θ−i ∈ (0, ∞), trader i ∈ I’s best response problem is maximising the
post-transaction utility by strategically choosing the submitted demand elasticity, i.e.,

θir (θ−i ) = argmaxVi (θi ; θ−i ). (2.8)

θi ∈[0,∞]

Remark 2.2.1 When aI = 0, Vi (θi ; θ−i ) = ui + ⟨ai , Cai ⟩ /2δi holds for all θi ∈ [0, ∞]. In this
case, the response function is flat, and any response leads to the same equilibrium prices
p(θi ; θ−i ) = 0 and allocation b
b qi (θi ; θ−i ) = −ai for trader i ∈ I, irrespectively of the value of θ−i .
These are exactly the prices and allocations one obtains at competitive equilibrium.
2.2 Traders’ Best Response Problem 21

The following result shows that, under the assumptions made in Section 2.1 (in particular,
that aI , 0), the best response problem (2.8) admits a unique solution (recall that β−i denotes
the difference 1 − βi , which is equal to j∈I\{i} β j ).
P

Proposition 2.2.2 Given θ−i ∈ (0, ∞), the best response of trader i ∈ I exists, is unique and
is given as follows:




 0, if βi ≤ −1;
θi (θ−i ) =  δi θ−i (1 + βi )/ (θ−i + δi β−i ) , if − 1 < βi < 1 + θ−i /δi ;
r

(2.9)



if βi ≥ 1 + θ−i /δi .

 ∞,


Proof: Fix θ−i ∈ (0, ∞). Making the monotone change of variable

θi
[0, ∞] ∋ θi 7→ ki := ∈ [0, 1],
θi + θ−i

and using a slight abuse of notation, maximising value function Vi is equivalent to maximising

ki2
!
(1 − ki )ki 1 − ki
Vi (ki ; θ−i ) = ui + ⟨aI , CaI ⟩ − − ⟨aI , Cai ⟩ (2.10)
θ−i 2δi θ−i
k2
!
(1 − ki )ki 1 − ki
= ui + ⟨aI , CaI ⟩ − i − βi .
θ−i 2δi θ−i

Since aI , 0, the above is a strictly concave quadratic function of ki ∈ [0, 1]; in particular, it
has a unique maximum. When βi ≤ −1 (resp., when βi ≥ 1 + θ−i /δi ), it is straightforward to
see that [0, 1] ∋ ki 7→ Vi (ki ; θ−i ) is decreasing (resp., increasing). It follows that θir (θ−i ) = 0
when βi ≤ −1, while θir (θ−i ) = ∞ when βi ≥ 1 + θ−i /δi . When −1 < βi < 1 + θ−i /δi , first-order
conditions in (2.10) give that the unique maximiser of [0, 1] ∋ ki 7→ Vi (ki ; θ−i ) is
!−1
θ−i
ki (θ−i ) = 2 +
r
(1 + βi ) . (2.11)
δi

It then readily follows from (2.11) that the unique maximiser of [0, ∞] ∋ θi 7→ Vi (θi , θ−i ) is
θir (θ−i ) = δi θ−i (1 + βi )/(θ−i + δi (1 − βi )) ∈ (0, ∞). □
According to Proposition 2.2.2, extreme best responses θi for trader i ∈ I are possible,
given θ−i ∈ (0, ∞). In fact, the best response is zero if and only if βi ≤ −1, irrespective of the
value of θ−i , and the best response is infinity if and only if βi ≥ 1 + θ−i /δi . In view of this
potentiality, it makes sense to understand how a trader would respond if θ−i itself took an
extreme value.
2.2 Traders’ Best Response Problem 22

We start with the case θ−i = ∞. In this case, taking the limit as θ−i → ∞ in (2.10) gives

θir (∞) = δi (1 + βi )+ . (2.12)

The case θ−i = 0 may be treated similarly, but it is worthwhile making an observation. Note
that θ−i = 0 means that all other traders except i ∈ I submit extremely inelastic demands.
According to the solution of the best response problem, and anticipating the definition of
Bayesian Nash equilibrium in Section 2.3, this only makes sense when β j ≤ −1 holds for
j ∈ I \ {i}. Since βi = 1 − j∈I\{i} β j and there are at least two traders, it should be that βi > 1.
P

In this case, taking the limit as θ−i → 0 in (2.10) gives θir (0) = ∞. To recapitulate: when
θ−i = ∞ the best response is given by (2.12). The case θ−i = 0 is interesting only in the case
βi > 1, where we set
θir (0) = ∞, whenever βi > 1.

It is clear from Proposition 2.2.2 that non-price-taking traders have motive to submit
demand function of different elasticity than their risk tolerance. The main determinant of
departure from the agents’ true demand is their pre-transaction beta, defined in (2.5). In order
to analyse the effect of strategic behaviour on the equilibrium prices and allocations, we may
consider the situation where trader i ∈ I is the only one acting strategically against price-
takers; all other agents submit the elasticity corresponding to their true demand functions for
the transaction. In symbols, we set θ−i = δ−i . This can be seen as a one-sided noncompetitive
equilibrium, in the sense that only trader i ∈ I exploits knowledge on other traders’ elasticity
and endowments, and responds optimally. The post-transaction beta (2.11) becomes kir = 0
when βi ≤ −1, kir = 1 when βi ≥ 1/λi , and kir = λi (1 + βi )/(1 + λi ) when βi ∈ (−1, 1/λi ). In
obvious terminology, we shall call the latter regime non-extreme, while the former two will
be called extreme.
It is completely straightforward from the closed-form expressions for kir that

λi < βi if and only if λi < kir < βi .

Taking into account the discussion following Proposition 2.1.2, the above fact implies that
traders have motive to submit more elastic demand functions if and only if they reduce
their market risk through the transaction. At the non-extreme regime, this happens when
βi ∈ (λi , 1/λi ), where the trader’s initial position is considered relatively more exposed to
market risk.
A direct outcome when acting more aggressively by submitting more elastic demand is
that the post-transaction beta entails more risk: indeed, instead of λi ⟨aI , S ⟩ at competitive
2.3 Noncompetitive Risk-Sharing Equilibrium 23

equilibrium, the (random part of) the portfolio after submitting demand with elasticity θir
equals kir ⟨aI , S ⟩. In particular, the post-transaction beta of trader i ∈ I is kir , instead of
λi . Although the reduction of risk exposure is lower when compared to the competitive
equilibrium, it comes at a better price. To wit, we readily calculate that in the whole
non-extreme regime βi ∈ (−1, 1/λi ) it holds that2

qri , pr < qri , b

p ,

which means that the gain of the strategic behaviour comes from the lower premium that is
paid.

Remark 2.2.3 Under the very special case βi = λi , one obtains θir (θ−i ) = δi , i.e., kir = λi . In
view of (2.4), the latter condition implies bqi = 0 and hence trader i ∈ I does not participate
in the sharing of risk; this is also the case in competitive equilibrium.

2.3 Noncompetitive Risk-Sharing Equilibrium

2.3.1 Nash equilibrium
With the best response problem (2.8) in mind, and assuming that all traders act strategically,
we now address noncompetitive Bayesian Nash equilibrium. More precisely, in a fashion
similar to the demand-submission game of Kyle (1989), traders submit linear demand
schedules of the form (2.7), where (θi )i∈I ∈ [0, ∞]I and θI = i∈I θi > 0 are the corresponding
P

individual and aggregate submitted demand elasticity. The market equilibrates at the pairs
of prices and allocations at which the submitted demands sum up to zero. According to
Proposition 2.1.2, as well as relations (2.3) and (2.4), for every submitted demands with
elasticities (θi )i∈I ∈ [0, ∞]I , the prices and allocations that clear out the market are given
by bp((θi )i∈I ) = −(1/θI )CaI , as well as bq j ((θi )i∈I ) = (θ j /θI )aI − a j , for each j ∈ I. In other
words, traders’ strategies are parametrised by their submitted elasticity within the family of
linear demands (2.7), according to the best response (2.2.2), and noncompetitive equilibria
are fixed points of these responses.
2
When β ∈ (−1, 1/λi ), the exact cash benefit from the best response strategy equals

λi (βi − λi )2
qri , b
p − pr = ⟨aI , CaI ⟩ .
δI (1 + λi )2 (1 − λi )

At competitive equilibrium trader i ∈DI paysE b qi , b

p = (βi − λi ) ⟨aI , CaI ⟩ /δI to reduce beta exposure to λi , while
acting strategically the trader pays qri , pr = (βi − λi ) ⟨aI , CaI ⟩ (1 − λi βi )/[(δI − δi )(1 + λi )2 ] to reduce beta
D E
exposure to kir . Note that qri , pr < b
qi , b
p , when βi ∈ (λi , 1/λi ).
2.3 Noncompetitive Risk-Sharing Equilibrium 24

Definition 2.3.1 A vector (θi∗ )i∈I ∈ [0, ∞]I , with θ∗I := θi∗ > 0, is called Nash equilib-
P
i∈I
rium or noncompetitive equilibrium if, for each i ∈ I,

Vi (θi∗ ; θ−i
∗
) ≥ Vi (θi ; θ−i
∗
), ∀θi ∈ [0, ∞].

By a slight abuse of terminology, we also call a Nash price-allocation equilibrium the

corresponding pair (p∗ , (q∗i )i∈I ) ∈ RK × RK×I given by

1 θi∗
p∗ = − ∗ CaI and q∗i = a I − ai , i ∈ I. (2.13)
θI θ∗I

where we set θi∗ /θ∗I = 1 whenever θi∗ = ∞, by convention.

From the discussion of Section 2.2, and particularly given (2.9) and (2.12), the possibility
of noncompetitive equilibrium where some traders behave as being risk neutral (i.e., θi∗ = ∞
for some i ∈ I) arises. We shall call such Nash equilibria where θ∗I = ∞ extreme, and any
other case where the total elasticity θ∗I belongs to (0, ∞) will be called non-extreme.

Remark 2.3.2 When aI = 0, it follows from Remark 2.2.1 that any vector (θi )i∈I ∈ R+I is
a Nash equilibrium, always resulting in the same Nash price-allocation with p∗ = 0 and
q∗i = −ai for all i ∈ I. Therefore, prices and allocations at competitive and Nash equilibria
coincide. In the sequel, we continue the analysis by excluding this trivial case aI = 0.

Remark 2.3.3 Having defined our notion of noncompetitive equilibrium, we highlight its
differences with the thin market models studied in Rostek and Weretka (2015), Malamud and
Rostek (2017). As pointed out in the introductory section, the price impact in these papers
equals the slope of the aggregate demand submitted by other traders. Traders respond to—or
equivalently, trade against—the price impact of their counter-parties forming a slope-game;
see (Rostek and Weretka, 2015, Lemma 1) and (Malamud and Rostek, 2017, Proposition
1). Our model keeps the form of equilibrium similar to the competitive one, as the family
of demands are linear and of the form (2.7); furthermore, although we parametrise traders’
strategies to the single control variable that is elasticity, the key element is that responses,
and hence equilibrium conditions, take into account the whole demand function of other
traders.

Our main goal in the sequel is to study existence and uniqueness of the aforementioned
linear Bayesian Nash equilibrium, and compare it with the competitive one. Departure
from competitive market structure reduces the aggregate transaction utility gain. Indeed, it
can be easily checked (see, for example, (Anthropelos and Žitković, 2010, Corollary 5.7))
2.3 Noncompetitive Risk-Sharing Equilibrium 25

that the allocation (bqi )i∈I of (2.4) maximises the sum of traders’ monetary utilities over all
possible market-clearing allocations. As utilities given by (2.1) are monetary, we can measure
the risk-sharing inefficiency of any noncompetitive equilibrium as the difference between
aggregate utility at Nash and competitive equilibrium.
We shall verify in the sequel that risk sharing in the noncompetitive equilibrium is, except
in trivial cases, socially inefficient. However, it is not necessarily true that each individual
trader’s utility is reduced; in fact, it is reasonable to ask which (if any) traders prefer Nash
risk sharing in such a thin market, as opposed to the corresponding market that equilibrates
in a competitive manner. For this, we compare the individual utility gains at two equilibria,
that is, the difference

DUi ≡ Ui Ei + q∗i , S − p∗ − Ui Ei + b
qi , S − b
p ,



for each i ∈ I, (2.14)
| {z } | {z }
utility at Nash equilibrium utility at competitive equilibrium

and ask when this is positive. Given this notation, and as discussed above, the inefficiency of
P
the noncompetitive risk-sharing is defined as the sum i∈I DUi .

2.3.2 Equilibrium with at most one trader’s beta being greater than
one
Under the condition3 that at most one of the traders have initial beta higher than one, that is

# {i ∈ I | βi > 1} ∈ {0, 1}, (2.15)

the next result states that there exists a unique linear noncompetitive equilibrium.

Theorem 2.3.4 Under (2.15), there exists a unique Nash equilibrium as in Definition 2.3.1.

According to (2.9), traders behave as being risk neutral when their initial exposure to
market risk is sufficiently higher than one. As we will show in Proposition 2.3.6 below, this
behaviour pertains at equilibrium, making it an extreme one, if and only if the following
condition holds: X
δi (1 + βi )+ ≤ 2 max(δi βi ). (2.16)
i∈I
i∈I

3
We conjecture that Theorem 2.3.4 is true in all cases, although we do not have a rigorous proof of this
claim.
2.3 Noncompetitive Risk-Sharing Equilibrium 26

When (2.16) fails, the (unique) Nash equilibrium is non-extreme; in this case, and in view of
(2.9), the following coupled system of equations

θ∗I − θi∗ θi∗

!
2+ = 1 + βi , ∀i ∈ I with βi > −1, (2.17)
δi θ∗I

should hold, where it is θ∗I which couples the equations. According to (2.9), any trader
i ∈ I with βi ≤ −1 optimally submits demand function with zero elasticity, inducing a
market-neutral post-transaction position, where recall that a position is called market-neutral
when it has zero induced beta. Theorem 2.3.4 states, in particular, that the system (2.17)
admits a unique solution for an arbitrary number of traders when (2.16) fails. This fact is
proved in Appendix A.1, and it is important to note that the proof is constructive, and hence
can be used to numerically calculate the equilibrium quantities when the number of traders is
more than two; the case of two traders admits in fact a closed-form solution and is extensively
studied in §2.4.1 later on.

2.3.3 Risk-neutral behaved trader(s)

Having established existence and uniqueness of Nash equilibrium in Theorem 2.3.4, we now
show that the condition (2.16) necessarily leads to an extreme noncompetitive equilibrium.
We start with an alternative characterisation of(2.16).

Lemma 2.3.5 Condition (2.16) is equivalent to

1 X
βk ≥ 1 + δi (1 + βi )+ , for some k ∈ I. (2.18)
δk i∈I\{k}

Furthermore, (2.18) can hold for at most one trader k ∈ I.

Proof: Start by assuming that (2.18) holds, and rewrite it as δk βk ≥ δk + i∈I\{k} δi (1 + βi )+ .

P

Since βk > 1, which implies that 1 + βk = (1 + βk )+ , adding δk βk on both sides of the

previous inequality and simplifying, we obtain 2δk βk ≥ i∈I δi (1 + βi )+ , from which (2.16)
P

follows. Conversely, (2.16) holds if and only if 2δk βk ≥ i∈I δi (1 + βi )+ holds for some
P

k ∈ I. In this case, βk ≥ 0 > −1, and subtracting δk (1 + βk ) = δk (1 + βk )+ we obtain

δk (βk − 1) ≥ i∈I\{k} δi (1 + βi )+ , which is (2.18).
P

Assume now that (2.18) held for two traders, say trader k ∈ I and l ∈ I with k , l. Then,
X X
δk (βk − 1) ≥ δi (1 + βi )+ ≥ δℓ (1 + βℓ ) and δl (βl − 1) ≥ δi (1 + βi )+ ≥ δk (1 + βk ).
i∈I\{k} i∈I\{l}
2.3 Noncompetitive Risk-Sharing Equilibrium 27

Adding up these inequalities we obtain −2(δk + δl ) ≥ 0, which contradicts the fact that δk > 0
and δl > 0. We conclude that (2.18) can hold for at most one trader. □
The next result gives a complete characterisation of extreme noncompetitive equilibrium;
in particular, it shows that at most one trader—and, in fact, exactly the trader k ∈ I for which
(2.18) holds—may behave as risk-neutral in noncompetitive equilibrium. Note that we do
not assume (2.15) for Proposition 2.3.6, as it was also not needed for Lemma 2.3.5

Proposition 2.3.6 An extreme noncompetitive equilibrium (i.e., with θ∗I = ∞) exists if and
only if (2.16), or equivalently (2.18), is true. In this case, we have θk∗ = ∞ for the unique
trader k ∈ I such that (2.18) holds, and θi∗ = δi (1 + βi )+ for i ∈ I \ {k}. In particular, the
previous is the unique extreme noncompetitive equilibrium under the validity of (2.16).

Proof: First, assume that a Nash equilibrium with θ∗I = ∞ exists. Since #I < ∞, there
exists k ∈ I with θk∗ = ∞. According to (2.12), for any trader i ∈ I \ {k}, it holds that
θi∗ = δi (1 + βi )+ . Therefore, for θk∗ = ∞ to be the best response for trader k ∈ I, (2.9) gives
βk ≥ 1 + (1/δk ) i∈I\{k} δi (1 + βi )+ . It follows that (2.18) is a necessary condition for existence
P

of an extreme noncompetitive equilibrium.

Conversely, if (2.18) holds, and defining θk∗ = ∞ and θi∗ = δi (1 + βi )+ for i ∈ I \ {k}, it is
immediate from (2.9) and (2.12) to check that the previous is indeed a Nash equilibrium. □
We proceed with some discussion, where we assume that (2.18) holds. In view of Propo-
sition 2.3.6 and the relations in (2.13), at the extreme equilibrium trader k ∈ I undertakes
all market risk, since q∗k = aI − ak , and the rest of the traders exchange all their market risk
(i.e., q∗i = −ai , for each i ∈ I \ {k}) at zero cost, since pricing is done in a risk-neutral way
(p∗ = 0). In particular, the post Nash-transaction beta of trader k ∈ I reduces to one, and all
other traders become market-neutral.
While this transaction is not socially optimal, participating traders increase their utilities;
otherwise, equilibrium would not form. Straightforward calculations give the individual util-
 D E
ity gains at the extreme equilibrium: Uk Ek + q∗k , S − p∗ = uk +(⟨ak , Cak ⟩ − ⟨aI , CaI ⟩) /2δk
 D E
and Ui Ei + q∗i , S − p∗ = ui +⟨ai , Cai ⟩ /2δi , for each i ∈ I \{k}. In particular, the difference
of utility gains in (2.14) between the extreme Nash equilibrium and the competitive one equal

⟨aI , CaI ⟩  ⟨aI , CaI ⟩

DUk = λk (2βk − λk ) − 1 , and DUi = λi (2βi − λi ), ∀i ∈ I \ {k}.

2δk 2δi
(2.19)
It follows by straightforward algebra that
X ⟨aI , CaI ⟩ 1 − λk
Risk-sharing inefficiency := DUi = − .
i∈I
2δI λk
2.4 Bilateral Strategic Risk Sharing 28

As expected, there is a reduction of the total utility gain when traders behave strategically
regarding the elasticity of their submitted demand functions. However, utility gains may be
higher in the noncompetitive equilibrium for individual traders. From (2.19), we conclude
that, in extreme noncompetitive equilibrium, traders that benefit from the market’s thinness
are the ones with sufficiently high initial exposure to market risk: for trader k ∈ I, when
βk > (1 + λ2k )/2λk and for traders i ∈ I \ {k} when βi > 2λi .4
The above quantitative discussion has the following qualitative attributes. Under condition
(2.18), in the noncompetitive extreme equilibrium trader k ∈ I reduces market-risk exposure
to one but pays zero premium to other traders. If the market’s equilibrium was competitive,
trader k ∈ I would decrease the post-transaction beta even more, to λk instead of to one, but
the premium would be strictly positive according to the decomposition (2.6). The benefit
of zero risk premium prevails the lower reduction of risk if βk is sufficiently large. On the
other hand, the rest of the traders sell all their market-risk exposure at zero premium. For
those traders with low initial beta (more precisely, βi < λi /2), the noncompetitive equilibrium
leaves them worse off than the competitive one. This stems from the fact that in competitive
equilibrium traders with low initial beta obtain premium from traders who are overexposed
to market risk, something that does not occur in the noncompetitive extreme equilibrium.
However, for traders with βi ≥ λi /2, the noncompetitive equilibrium is preferable since they
also benefit from the zero risk premium.
To recapitulate: traders that obtain more utility from the extreme noncompetitive equilib-
rium are the ones with sufficiently high initial exposure to market risk.

2.4 Bilateral Strategic Risk Sharing

2.4.1 The case of essentially two strategic traders
As pointed out in the introductory section, the two-trader case is of special interest since the
majority of the OTC transactions consists of only two institutions, or one institution and a
client.
Since traders with pre-transaction beta less or equal to −1 always sell all their risk at
equilibrium, a risk-sharing game is essentially between two traders if exactly two of them
(for concreteness’s sake, traders 0 ∈ I and 1 ∈ I) have pre-transaction beta larger than −1.
4
As easy examples show, condition (2.18) does not necessarily imply βk > (1 + λ2k )/2λk . In the special
two-trader case I = {0, 1} with k = 0, condition (2.18) is equivalent to β0 > 2 − λ0 , which always implies
β0 > (1 + λ20 )/2λ0 when λ0 > 1/3. Still in the same two-trader case with k = 0, condition (2.18) implies that
β1 < 2λ1 : in the bilateral extreme equilibrium, only the trader that acts as risk neutral could benefit from the
market’s thinness.
2.4 Bilateral Strategic Risk Sharing 29

Then, traders 0 and 1 are the only ones to submit demands with non-zero elasticity. In view
of the general analysis of §2.3.3, we shall only treat the case of non-extreme equilibrium, i.e.,
when (2.16) fails. Straightforward algebra yields that, in the present case, failure of (2.16) is
equivalent to the following simplified inequality

|λ0 β0 − λ1 β1 | < λ0 + λ1 . (2.20)

If I = {0, 1}, and recalling that β0 + β1 = λ0 + λ1 = 1 in this case, inequality (2.20) is

equivalent to −λi < βi < 2 − λi for both i ∈ {0, 1}.

Proposition 2.4.1 Assume that β0 > −1, β1 > −1, βi ≤ −1 for i ∈ I \ {0, 1}, and impose
(2.20). Then there is a unique noncompetitive equilibrium that satisfies θi∗ = 0 for i ∈ I \ {0, 1},
as well as
2λ1 (β0 + β1 ) 2λ0 (β0 + β1 )
θ0∗ = δ0 , θ1∗ = δ1 . (2.21)
(λ0 + λ1 ) + (λ1 β1 − λ0 β0 ) (λ0 + λ1 ) + (λ0 β0 − λ1 β1 )

Proof: As already mentioned, Proposition 2.2.2 implies that the best response for each
trader i ∈ I with βi ≤ −1 is zero; for traders 0 and 1, θ0∗ and θ1∗ should satisfy (2.17). In this
case of essentially two traders, the system takes the form of the following two equations

(2δ0 + θ1∗ )θ0∗ = δ0 (1 + β0 )(θ0∗ + θ1∗ ) and (2δ1 + θ0∗ )θ1∗ = δ1 (1 + β1 )(θ0∗ + θ1∗ ). (2.22)

Subtracting the first equation from the second and dividing by θ∗I = θ0∗ + θ1∗ gives

2(δ1 k1∗ − δ0 k0∗ ) = δ1 (1 + β1 ) − δ0 (1 + β0 ), (2.23)

where ki∗ ≡ θi∗ /(θ0∗ + θ1∗ ) for i ∈ {0, 1}. Since k1∗ = 1 − k0∗ , (2.23) is a simple linear equation of
k0∗ whose unique solution is
1 λ0 β0 − λ1 β1
k0∗ = + . (2.24)
2 2(λ0 + λ1 )
The first equation in (2.22) can be written as (2δ0 + θ1∗ )k0∗ = (1 + β0 )δ0 , which together with
(2.24) implies that θ1∗ should be given as in (2.21). A symmetric argument shows that θ0∗
should also be given as in (2.21). Finally, note that assumption (2.20) and the imposed
condition βi ≤ −1, for each i ∈ I \ {0, 1} guarantee that both θ0∗ and θ1∗ are strictly positive and
finite. □
At the above noncompetitive equilibrium, prices are given by p = −CaI /(θ0 + θ1 ), while
∗ ∗ ∗

the allocation is q∗i = aI θi∗ /(θ0∗ + θ1∗ ) − ai for each i ∈ I, i.e. only trader 0 and 1 are left with
market risk after the transaction.
2.4 Bilateral Strategic Risk Sharing 30

Remark 2.4.2 As can be readily checked, a combination of Proposition 2.3.6, Theorem 2.3.4
and Proposition 2.4.1 completely covers all possible configurations for trades including
up to three players. On the other hand, one may find a configuration of four traders that
is not covered by the results; for example, with I = {0, 1, 2, 3} and δi = 1 for all i ∈ I, let
β0 = β1 = 2, β2 = 0, β3 = −3.

For the rest of this section we focus our analysis and discussion on bilateral transactions,
where we assume that I = {0, 1}. For the reader’s convenience, we note the following result
stemming immediately from Proposition 2.4.1.

Corollary 2.4.3 When I = {0, 1} and under inequality (2.20), there is a unique linear
noncompetitive equilibrium given by
!
2λ1 2λ0
(θ0∗ , θ1∗ ) = δ0 , δ1 .
λ1 + β1 λ0 + β0

The corresponding price-allocation equilibrium is given by

δI (λ0 + β0 )(λ1 + β1 ) (λ0 + β0 )(λ1 + β1 )

p∗ = − CaI = p, (2.25)
4δ0 δ1 4λ0 λ1
b

and
λi + βi qi βi aI − ai
q∗i = aI − ai = + , i ∈ {0, 1} .
b
2 2 2
Remark 2.4.4 The only case where the allocation at noncompetitive equilibrium coincides
with the competitive one is when β0 = λ0 , which necessarily implies that β1 = λ1 also holds.
This equality, however, means that the competitive equilibrium is a trivial no-transaction
equilibrium, since (2.4) gives q∗0 = 0 = q∗1 .

As expected from the analysis of Section 2.2, relatively higher initial exposure to market
risk implies more higher submitted elasticity at the noncompetitive equilibrium: for each
i ∈ {0, 1},
δi < θi∗ ⇔ λi < βi ⇔ λ−i > β−i .

In particular, the trader who reduces (resp., increases) exposure to market risk through the
transaction submits a demand function with higher (resp., less) elasticity than the one that
corresponds to that trader’s risk tolerance.
The above analysis implies that the trader with higher initial exposure to market risk is
willing to retain some of this risk in exchange for a lower risk premium. Correspondingly,
the trader who undertakes further market risk through the transaction tends to behave in a
2.4 Bilateral Strategic Risk Sharing 31

more risk averse way, hesitating to undertake more risk at the same risk premium. The direct
outcome is that the volume of risk sharing is lower than the one obtained at competitive
equilibrium, which leads to risk-sharing inefficiency. In fact, simple calculations yield that
the Nash post-transaction beta of trader i ∈ I changes from βi to (λi + βi )/2, instead of a
competitive—and socially optimal—post-transaction beta of λi . In other words, for both
traders the noncompetitive equilibrium transaction makes their betas exactly equal to the
middle point between the initial and the socially optimal ones.

Remark 2.4.5 From (2.25), we can easily see that p∗ = b p holds if and only if λ0 = β0 or
λ0 = (2 − β0 )/3. While the former case is the trivial one (with zero volume at any equilibrium),
the latter gives a special non-trivial case where prices remain unaffected by the traders’
strategic behaviour. In this case, the Nash post-transaction beta is (λi +βi )/2 = (1+βi )/3 = λ−i
for both i ∈ {0, 1}.

Similar to the decomposition of utility gains at competitive equilibrium in (2.6), we

decompose the corresponding utility gains at noncompetitive equilibrium for i ∈ {0, 1} as

1  λ + β 2 ⟨a , Ca ⟩ βi − λi
i i I I
Ui Ei + q∗i , S − p∗ = ui + ⟨ai , Cai ⟩ − ⟨aI , CaI ⟩ L,


−
2δ
| i
{z 2 2δi
} | δ I
{z }
profit/loss from random payoff (signed) risk premium
(2.26)
where L ≡ (β0 + λ0 )(β1 + λ1 )/8λ0 λ1 . The decompositions (2.6) and (2.26) give an expression
for the utility difference between the two equilibria DUi defined in (2.14); to wit,

⟨aI , CaI ⟩ 2  λi + βi 2 βi − λi
" #
DUi = λi − + ⟨aI , CaI ⟩ (1 − L), i ∈ {0, 1} . (2.27)
2δi 2 δI

As was the case in extreme equilibrium discussed in §2.3.3, the difference of utility
gains stems from two sources: the gain from sharing the random (risky) payoffs and the risk
premium paid or received. Lets assume without loss of generality that β0 < λ0 (or equivalently,
that β1 > λ1 ), i.e., that trader 0 undertakes more market risk after the (competitive or not)
transaction. Since noncompetitive risk-sharing beta reaches only halfway compared to
competitive risk-sharing, there is less risk undertaken by trader 0. The risk premium received
for undertaking market risk is higher than the one in competitive equilibrium if and only if
L > 1, which holds in particular when λ0 is close to one. When λ0 is not close to one, the
risk premium is lower and could absorb all the gain from the lower undertaken market risk.
Hence, for traders who undertake market risk at the transaction and have risk preferences
close to risk neutrality, the noncompetitive equilibrium is more beneficial.
2.4 Bilateral Strategic Risk Sharing 32

On the other hand, trader 1 is selling market risk, with lower reduction of Nash post-
transaction beta (a fact that decreases utility), while the premium is lower at Nash equilibrium
if and only if L < 1. The difference 1 − L is negative for λ1 close to zero, and the total
difference (2.27) for i = 1 remains negative when β1 < 1 for every value of λ1 . For fixed λ1 ,
L is decreasing in β1 (when β1 > 1 − λ1 ) and the total difference (2.27) for i = 1 is positive
when β1 is close to its upper bound 2 − λ1 .
Finally, it should be pointed out that when the risk preferences of trader 0 (i.e., the buyer
of market risk) are close to risk neutrality (that is, when λ0 is close to 1), the noncompetitive
equilibrium is always better than the competitive one if and only if |β0 | < 1 or, equivalently,
when 0 < β1 < 2. In particular, (2.27) and the discussion of extreme equilibrium in §2.3.3
imply that

 ⟨aI , CaI ⟩ (1 + β0 )(1 − β0 )2 /8δ1 , if β0 ∈ (−1, 1);

lim DU0 = 

δ0 →∞  0,
 otherwise.

Therefore, within non-extreme Nash equilibrium, traders that obtain more utility in the
noncompetitive equilibrium are the ones with risk preferences close to risk neutrality.
Overall, we conclude that in two-trader transactions, traders that benefit with more utility
from the noncompetitive equilibrium are the ones with sufficiently high initial exposure to
market risk, and traders with sufficiently high risk tolerance.

2.4.2 The effect of incompleteness in thin markets

As emphasised above, our model allows the market to be incomplete, in that the tradeable
securities do not necessarily belong to the span of the traders’ endowments. When traders’
endowments are not securitised, risk-sharing through competitive trading of other securities
is sub-optimal. The goal of this section is to examine the effect of a market’s incompleteness,
both on aggregate and individual levels, when the risk-sharing is noncompetitive. For this
goal, we consider the indicative two-trader game, I = {0, 1}.
In order to examine the effect of a market’s incompleteness we compare two market
settings: an incomplete one, and one where S = E. To highlight the effect of incompleteness,
we assume that besides (lack of) completeness, the rest of the parameters are the same; in par-
ticular, risk aversions remain the same, and projected and actual betas are equal. We take into
account the individual utility gains (2.6), (2.26) and utility difference (2.27). For quantities
pertaining to the complete market we use notation with superscript “o”, that is, (qoi , po ) are
the noncompetitive equilibrium allocations and price and q̂oi the allocation under competitive
equilibrium. Straightforward calculations give the following decomposition of utility gains,
2.4 Bilateral Strategic Risk Sharing 33

in terms of gains in competitive equilibrium and the effect of market noncompetitiveness:

1 2
Utility gain in incomplete setting = Ui Ei + q∗i , S − p∗ − ui = C 1/2b + DUi


qi
2δi {z }
|
gain in competitive equilibrium
1 2
Utility gain in complete setting = Ui Ei + qoi , E − po − ui = Cov1/2 (E, E)q̂oi + DUoi .


2δi
| {z }
gain in competitive equilibrium

Based on the above, we notice the following: The first term represents the gains of the
risk-sharing if the markets were competitive. In particular, we have that (see also Proposition
2.7 in Anthropelos (2017))

2 2
qi = Cov(S , λi E I − Ei )C −1 Cov(S , λi E I − Ei ) ≤ Var(λi E I − Ei ) = Cov1/2 (E, E)qoi ,
C 1/2b

where equality holds if, and only if, S belongs in the span of E. The above inequality
means that, under a competitive market setting, each trader loses utility due to the market’s
incompleteness.
The effect of the market’s incompleteness on the noncompetitive transaction, after ac-
counting for the differences in the competitive environment, is captured by the difference
DUoi − DUi . In view of (2.27), we have

⟨aI , CaI ⟩ 2  λi + βi 2
" #
DUi = λi − + 2λi (βi − λi )(1 − L) , i ∈ {0, 1} . (2.28)
2δi 2

Keeping the parameters βi , λi equal for the complete and incomplete market settings, the only
difference stems from the term ⟨aI , CaI ⟩. In the incomplete market setting this term equals
Cov(S , E I )C −1 Cov(S , E I ), while in the complete market setting it equals Var(E I ). Since

Cov(S , E I )C −1 Cov(S , E I ) ≤ Var(E I ), (2.29)

market incompleteness decreases (resp., increases) the utility gain (resp., loss) that is caused
by the market’s noncompetitiveness. In other words, traders that benefit from the noncom-
petitive market setting (i.e., those with high risk tolerance and/or high exposure to market
risk), have their utility gains reduced by the fact that endowments are not securitised. More
precisely, we have seen that traders with relatively high exposure to market risk behave as
risk neutral in order to reduce their exposure to one without paying risk premium. When the
market is complete the reduction of the risk is more effective, since the traders sell part of their
endowments and not a security that is simply positively correlated with their endowments, as
2.4 Bilateral Strategic Risk Sharing 34

in the incomplete setting. Recall also that the utility gain of the traders with relatively lower
risk aversion under noncompetitive setting stems from the lower (resp., higher) risk premium
that they pay (resp., receive). From (2.26), we get that the risk premium is always higher in
the complete market setting (see also (2.29)) and hence the aforementioned increase (resp.,
decrease) of risk premium is also higher in the competitive setting.
We may conclude that, although market’s incompleteness reduces the aggregate efficiency
of risk-sharing, it also reduces the differences of utility gains/losses among traders.
Chapter 3

The Effect of Market Conditions and

Career Concerns in the Fund Industry

3.1 Introduction
In recent years, there has been growing concern in the financial markets about the role of
various financial intermediaries such as mutual funds and hedge funds, as the proportion of
the institutional ownership of equities has sharply increased and the Global Assets under
Management are estimated to exceed $100 trillion by 20201 . The managers of these funds
are competing with each other, but also with alternative investment vehicles such as market
index funds or ETFs, to attract new investors. One of the ways in which they differentiate
themselves is through their investment strategy. In particular, managers often signal their
confidence by choosing strategies that are highly idiosyncratic2 , and more importantly their
incentive to pick these strategies fluctuates with the general market conditions.
Our first contribution is to build a model in which a manager’s investment decision
provides an imperfect signal on her ability to generate idiosyncratic returns. To be more
precise, the manager will skew her investment choice towards a strategy with low exposure
to the market in order to signal her confidence. A highly skilled manager is more likely to
invest in her idiosyncratic project, since this will deliver on average superior returns. The
investors cannot observe directly the manager’s ability, but because of the above they will
associate an idiosyncratic strategy with a competent manager; in turn, this will endow such a
strategy with a reputational benefit. This asymmetry of information between the manager
and her potential investors is the main driving force behind the results of this paper.
1
This is according to a research by PWC.
2
For example, a recent article in Financial Times explains how institutional investors are turning to alternative
investments in recent years.
3.1 Introduction 36

Our second contribution is to demonstrate that the signalling value of investing in a low
beta strategy depends on the market conditions. Managers have a dual objective; they want
to maximise their contemporaneous returns but also their perceived reputation. The better
the market (bull) is, the more the managers face a trade-off between these two objectives,
and the less the investors penalise managers for choosing a high beta strategy. Consequently,
there is an interaction between managers’ career concerns and market conditions.
To analyse the above interactions we consider a two period model in which there is a
continuum of investors and a single fund manager. Each investor chooses between investing
his wealth through the manager, or directly in the market index, and this choice is affected by
an investor’s specific stochastic preference shock. The manager’s utility is a function of the
fees she collects, which are an exogenous proportion of her fund’s assets under management
(AUM) at the end of each period. After the investors have allocated their funds, the manager
publicly chooses between a high or low beta investment strategy. We model the manager’s
ability as the ex ante expected return of her idiosyncratic strategy, which is either high or
low. In each of the two periods, and before picking an investment strategy, the manager also
receives a private signal on the contemporaneous profitability of her idiosyncratic project.
Both her ability and this signal are her private information, and she uses them to form her
final estimate of the profitability of her contemporaneous idiosyncratic strategy. As a result,
a high type manager is more likely to form a high estimate, but this is not always the case.
To model market conditions, we assume that the manager also receives a signal on the
market’s contemporaneous return. This signal is eventually revealed to the investors, but
only after they have made their own investment choice. In some sense, we allow for them to
eventually understand the market conditions under which the manager acted. However, at
this point it will be too late for them to use this information to trade on their own3 . In section
3.3.4, we extend our setting by allowing two managers to coexist in the market, in order to
study how the competition is affected by market conditions. We focus mainly on the first
period, since in the second the manager’s investment choice is not affected by her reputational
concerns. In fact, the second period is introduced in order to create those concerns.
For our first result, we analyse a refinement of the perfect Bayesian Equilibrium, which
we call monotonic equilibrium and we prove that this always exists. The only additional
restriction that this refinement is imposing is that the manager’s reputation is non-decreasing
on her performance. In addition, under mild parametric restrictions we demonstrate that the
monotonic equilibrium is unique.
In our second result we demonstrate that investing in an idiosyncratic strategy carries a
reputational benefit. This is because, the cut-off of the high manager type is smaller than that
3
In other words, manager has a superior market-timing ability compared to an investor.
3.1 Introduction 37

of the low. In other words the high type is more receptive to the idea of adopting a low beta
strategy. Intuitively, the manager’s choice is affected by two incentives. On the one hand,
she wants to increase her reputation, which skews her preferences towards idiosyncratic
investments. On the other hand, she cares about the realised return of her strategy, since her
fees depend on it. Hence, for a relatively low private signal even a high type may opt to
forfeit the reputational benefit, because investing in the market will generate higher returns,
and as a result more fees. Therefore, the investment strategy is informative but it does not
fully reveal the manager’s ability, which is a realistic representation of the fund industry.
Our third and most important result is to show that the reputational benefit of investing in
the idiosyncratic project is decreasing in the market conditions. In particular, we prove that
the expected sensitivity of reputation to performance is higher in bear markets than in bull
markets. This is because investors understand the dual objective of managers and the fact
that a manager is more likely to invest in the market when the market conditions are good,
and thus update their beliefs less aggressively when this is the case; instead, in bad times
any change in a fund’s performance is much more likely to be attributed to the ability of the
manager.
We use the above results to discuss the competition between funds, in terms of their sizes,
and its fluctuation depending on market conditions. We predict that the likelihood of changes
in the ranking of the funds, measured by assets under management, is hump shaped on the
market return, but is also higher during bear markets than during bull markets, due to the
higher informativeness of performance; we also find some empirical evidence supporting
this prediction. This is in line with the common perception that the industry only rearranges
its interaction with its investors during crises.
Finally, as an extension to our model, we study the case where investors cannot observe
the managers’ investment decision. In this scenario, we assume that the investors cannot
observe if the manager had invested on the market or their idiosyncratic portfolio, and
we conclude that, under this assumption, the conditions for the existence of a monotonic
equilibrium cannot be satisfied.
Academic research in financial intermediaries has so far mainly focused on establishing
various empirical results about their structure, returns, flows, managers’ skill and many other
characteristics; there have been far fewer theoretical papers. One of the seminal papers about
mutual funds is from Berk and Green (2004); they construct a benchmark rational model in
which the lack of persistence of outperformance, is not due to lack of superior skill by active
managers, but is explained by the competition between funds and reallocation of investors’
capital between them.
3.1 Introduction 38

Our paper aims to contribute to various strands of literature that we outline below. First, it
relates to many papers that study how managers’ concerns about their reputation affect their
investment behaviour. Chen (2015) examines the risk taking behaviour of a manager who
privately knows his ability and shows that in this model investing in the risky project always
makes a manager’s reputation higher, thus leading to overinvestment in such risky projects.
Dasgupta and Prat (2008) study the reputational concerns of managers, and show how they
may lead to herding and can explain some market anomalies; their focus though is mainly
on the asset pricing implications of this behaviour. Similarly, Guerrieri and Kondor (2012)
build a general equilibrium model of delegated portfolio management to study the asset
pricing implications of career concerns; they find that as investors update their beliefs about
managers, these concerns lead to a reputational premium, which can change signs depending
on the economic conditions. Moreover, Malliaris and Yan (2015) show that career concerns
induce a preference over the skewness of their strategy returns, while Hu et al. (2011) present
a model of fund industry in which managers alter their risk-taking behaviour based on their
past performance and show that this relationship is U-shaped. Huang et al. (2012) on the
other hand, build a theoretical framework to show how investors are rationally learning about
the managers’ skills, and test their predictions about the fund flow-performance relationship
empirically; however, they do not take into account any strategic behaviour by the fund
managers.
The paper most relevant to our work is that by Franzoni and Schmalz (2017). In their work,
they study the relationship between the fund to performance sensitivity and an aggregate
risk factor and they find that this is hump shaped. They also build a theoretical model in
which investors update their beliefs about the managers’ skills while they also learn about
the fund’s exposure to the market. The second inference in extreme markets is noisier for
two reasons. The first is idiosyncratic risk and the second is that investors who are uncertain
about risk loadings cannot perfectly adjust fund returns for the contribution of aggregate
risk realisations. As a result it becomes harder for investors to judge the managers and
update their beliefs, and this is what drives the documented result. The theory we propose
differs from that of Franzoni and Schmalz (2017) because their model describes the fund’s
loading on aggregate risk (β) as a preset fund specific exposure, whereas our model gives
the ability for managers to strategically choose their investment decision. Also we further
investigate how this investment decision will affect the managers’ decision if it is observable
by the investors or not. Moreover the data source considered for their paper is the CPRSP
Mutual Fund Database which is different from the Morningstar CISDM which we use for
the empirical part, making it difficult to compare our results. Although the implementation
and the structure of their model is completely different to ours and does not imply the same
3.1 Introduction 39

predictions we are making, we conclude that the aggregate risk realisations matter for mutual
fund investors and managers.
Another strand of literature in which we contribute to, is the empirical research on
the fund flows and characteristics. It is well documented that mutual fund investors chase
past returns, Ippolito (1992) and Warther (1995) present empirical evidence supporting our
predictions. Sirri and Tufano (1998) show that the flow-performance relationship is convex,
and asymmetrically so on the positive side of returns. Furthermore, Chevalier and Ellison
(1997), show that managers engage in window dressing their portfolios. More recently, Wahal
and Wang (2011) study the competition between funds, by looking at the effect of the entry
of new mutual funds on fees, flows and equilibrium prices. Finally, Ma (2013) provides a
very comprehensive survey of empirical findings concerning the relationship between mutual
fund flows and performance.
The rest of the paper is organised as follows. In section 3.2, we introduce our theoretical
framework and our equilibrium. Section 3.3 proves its existence, identifies a condition under
which this is unique, and presents our theoretical predictions. In particular, section 3.3.4
discusses the implications of adding a second manager. Subsequently, section 3.4 presents our
empirical results. Section 3.5 considers an alternative model where the investment decision
is unobservable. Finally, section 3.6 concludes.
3.2 The Model 40

3.2 The Model

3.2.1 Setup
This is a two period model t ∈ {1, 2}. There is one fund manager (she) and a continuum of
investors (he) of measure one, who collectively form the market. The manager discounts the
future with δ ∈ (0, 1].
At the beginning of period t, each investor decides how to invest a unit of wealth. At the
end of period t, he consumes all the wealth that this investment generated. The investor is
restricted to a binary decision. He can either opt to allocate all his wealth in an index tracking
strategy. This has the same returns as the market portfolio, which is given by

mt ∼ N(µ , σ2m ) (3.1)

Or, he can choose to invest all his wealth in the manager’s fund4 . For each unit of wealth
invested with the manager let Rt = exp(rt ) denote its value at the end of this period, where

rt = (1 − βt ) · at + βt · mt (3.2)

is the fund’s return. This has two components, one of which is the market return mt . The
second is given by
at ∼ N(α, σ2 ) (3.3)

which represents the market neutral component of the manager’s investment strategy5 . Ad-
hering to the fund industry’s convention, the manager’s ability to create idiosyncratic profits
is called alpha, and is represented by α ∈ {L, H} where L < H. The manager’s ability is her
private information. The investors share the public prior π = P(α = H).
Finally, βt represents the fund’s exposure to the market. This is publicly chosen by
the manager after the investors have allocated their wealth. For simplicity we assume that
βt ∈ {0, 1}. Note that the model’s beta βt despite its relevance to the corresponding variable
4
Our underlining intuition is that most of the market participants follow a rule of thumb to their investment
through intermediaries. For example, they set apart 5% of their wealth and then they decide if they should
invest this amount to a fund.
5
For example think of a long/short equity fund that invests (1 − βt ) of its assets on a market neutral
portfolio and βt on the S&P 500 index. For the most part we refrain from giving a specific interpretation of the
components of the fund’s return rt , or which part of its investment strategy they represent. Our framework relies
on the simple intuition that some of the return generated by the manager stems from her own ability and some
from factor loading. In fact mt could represent any such factor, and for some funds other choices would be more
sensible. For example, a macro fund is more related to the risk-free interest rate than to the equity markets.
3.2 The Model 41

of the CAPM model, is not the same variable. Rather the former represents a deterministic
investment decision, whereas the latter its estimate.
In addition, before making her investment decision βt , but after the investors have
allocated their wealth, the manager receives two signals

st ∼ N(at , ν2 ) and smt ∼ N(mt , νm2 ). (3.4)

On the one hand, st is private and it is associated to the manager’s contemporaneous con-
fidence on her alpha6 . On the other hand, smt is public but it only becomes available after
the investors have committed their capital to the manager’s fund. This market signal is
considered to be the standard piece of information that most institutional participants receive
on the market’s condition.
To simplify matters, we assume that the manager’s fees are exogenously set to a given
percentage ft ∈ [0, 1] of her asset under management (AUM) at the end of t7 . Even though
we do not allow for incentive fees, the plain managerial fees ft we consider suffice to create
direct incentives for the manager to perform in t, as her period income per dollar invested is
ft Rt .
Two more important assumptions have been made. First, that the manager’s investment
decision is binary. In particular, it allows for either investing all of the fund’s assets in the
manager’s idiosyncratic strategy at , or all in the market mt . Second, that this decision is
observable by the rest of the market participants. The former assumption is imposed mainly
to make the model more tractable. We speculate that altering it to allow for βt ∈ {b, b}, where
b < b, would not affect our results qualitatively8 . Regarding the latter assumption, it appears
to be reasonable for long investment horizons. This is because the fund’s exposure to the
market can be ex-ante approximately inferred, either by estimating a multi-factor regression,
or by looking at its past portfolio composition, which in many cases is public.
6
This could reflect the fact that her idiosyncratic strategy has some seasonality that she is able to partly
predict. Another interpretation is that the strategy itself changes across periods, in which case α represents the
manager’s latent ability to come up with new ideas to beat the market.
7
Endogenising the choice of fees is left for future research. The complexity of allowing an endogenous
choice is that the fees would then serve as a signalling device for the managers’ ability, thus making the
equilibrium much harder to find.
8
A possibility that we exclude and is worth mentioning is that of a manager that bets against the market. In
particular, in strong bear markets most funds would prefer to short the market portfolio, instead of adopting a
strategy that is neutral to it. This would have a significant impact on our analysis. Despite that, it is ignored
both to facilitate the exposition and because funds that systematically hold big negative positions are not that
common.
3.2 The Model 42

3.2.2 Payoffs
Investors are risk-neutral, however each one’s decision is influenced by an exogenous
preference shock which follows an exponential distribution.

ztj ∼ exp(λ) ,
 
where j ∈ 0, 1 (3.5)

stands for the shock on investor’s j preferences at period t and λ is the rate parameter of the
exponential distribution. Hence, his payoff from investing in i ∈ {1, m} is

 exp(zt − z̄) · (1 − ft ) · Rt , i = 1
 j
v(i, ztj ) =

(3.6)

 exp(mt ) ,i = m

where z̄ > 0 is a constant that we introduce to ensure that under the lowest preference shock
ztj = 0 the investor would opt for the market instead.
There is a plethora of ways to interpret this shock, a valid one being that each investor
values specific fund characteristics, for example the fund’s classification with regards to its
investment strategy, its portfolio composition, leverage, etc. An alternative one would be
that he is influenced by interpersonal relationships, network effects, word of mouth, or other
forms of private information. Our analysis will be silent as to what generates this shock.
Furthermore, note that because Rt comes from a log-normal distribution, we could adopt
a CRRA utility function for the investor without altering his decision significantly. However,
we opt not to do so in order to maintain our expressions as compact as possible. On the other
hand, it will be assumed that the manager has log preferences. In particular, if At stands for


the AUM the fund in the beginning of t, then manager’s payoff at t is log At ft Rt . Again we
speculate that most of our results would not be significantly different if a generic CRRA was
used instead of log, however it turns out that this is the most convenient functional form to
work with.

3.2.3 Timing
To sum up, the timing in our model is as follows. In each period t ∈ {1, 2}, first the preference
shock ztj , j ∈ [0, 1], is realised and then the investors decide how to allocate their wealth.
Second, the manager receives the private and public signals st and smt , respectively. Third,
the investment decision βt is made by the manager, Rt is realised, and both become public.
Fourth, the fund’s AUM is divided between the manager and her investors, according to
the fee ft , and is consumed immediately. Finally, we assume that the investors that are
active in the second period observe the public variables of the first period before allocating
3.3 Analysis 43

their wealth. Importantly, they know (R1 , β1 , sm1 ) and use them to update their beliefs on the
manager’s ability α. Signal s1 can not be used since it is private information of the manager
and it will never be known to the investors.

3.2.4 Monotonic equilibrium

We call an equilibrium of our model perfect Bayesian (PBE), if all market participants use
Bayes’ rule to update their beliefs on α, whenever possible, and choose their actions in order
to maximise their expected discounted payoff at each point they are taking an action. There
is a possibility of there being multiple equilibria, which is a common setback for these types
of models. For this reason we will further refine the set of equilibria using the following
definition, however, the study of these equilibria is beyond the scope of this paper.
Definition. Call a PBE a monotonic equilibrium if the manager’s reputation, for a given
choice of investment strategy, is non-decreasing on her performance.
In other words a monotonic equilibrium satisfies P(α = H | r, sm , β) is increasing in r.
Therefore, the only requirement that our refinement imposes is that the manager’s reputation
is not penalised by the fact that she delivers good returns for her investors. The above
definition implies that there exists φ0 and φ1 such that the public posterior on the manager’s
ability is given by

φ0 = P(α = H | r1 , sm1 , β1 ), for β1 = 0

(3.7)
φ1 = P(α = H | r1 , sm1 , β1 ), for β1 = 1

We separate the posteriors that follow each choice of β1 because those will turn out to have
different functional forms.

3.3 Analysis
We begin our analysis by first discussing the manager’s optimal investment strategy in the
second period and how this affects her career concerns in the first period. Second, we
characterise the monotonic equilibrium and prove its existence and uniqueness. Third, we
present our results on the baseline model with the single manager. Fourth, we discuss the
implications of adding a second manager.
3.3 Analysis 44

3.3.1 Investment and AUM in the second period

Here we provide a description of how we solve for the manager’s investment decision in the
second period and the corresponding AUM that this implies. The interested reader can find a
more detailed analysis in Appendix B.2.
In the second period the manager faces no career concerns. Hence, the objective of her
investment decision is to maximise the expected fees she collects at the end of this period.
Because those fees are proportional to her fund’s AUM at the end of the second period, and
we have assumed log preferences, the manager’s payoff maximisation problem simplifies to

max E log(A2 , f2 , R2 ) β2 , α, s2 , sm2

 
β2 ∈{0,1}

When opting for her idiosyncratic strategy β2 = 0 the above expectation uses the manager’s
ability α and private signal s2 , whereas the index tracking strategy β2 = 1 depends only on
the market signal sm2 . Since we have assumed that the returns and the corresponding signals
are log-normally distributed we can calculate the above expectation for each choice in closed
form. This suggests that the manager’s optimal second period strategy is to invest in her
idiosyncratic project if and only if s2 ≥ c(α, sm2 ) where

ψm m 1 − ψm 1−ψ
c(α, sm2 ) = · s2 + ·µ− ·α (3.8)
ψ ψ ψ

The constants ψ and ψm are the weights that the Bayesian updating gives to the signals s2
and sm2 , respectively, and their functional form can be found in Appendix B.2. Given the
above cut-off strategy we can calculate the expected terminal value of one unit of wealth
that is invested by the manager. For a high and low type we will denote those by u2H and u2L ,
respectively. Therefore, for given posterior reputation φ, and while ignoring the preference
shock z, the expected payoff of an investor that opts for the manager is given by

[1 − f2 ] · [φ · u2H + (1 − φ) u2L ]

This together with the assumed preference shock allows us to calculate the assets of the
second period in closed-form.
From (3.6) we have the expected payoff of an investor who chooses to invest in a fund
or in the market. He chooses the former if his expected payoff is higher. Since there is a
continuum of investors with one unit of wealth, the probability of this event occurring is
equal to the assets of fund one. Hence
3.3 Analysis 45

λ
A2 (φ) = e−(µ+z̄+σm /2) · [1 − f2 ] · [φ · u2H + (1 − φ) · u2L ]
2

(3.9)

which is an increasing function of the manager’s reputation φ. One thing we can note is
that as long as λ > 1, the assets under management are a convex function of the reputation
φ. This is a result that has been widely documented in the relevant empirical literature, in
slightly different forms.

3.3.2 Existence and uniqueness of the monotonic equilibrium

In this section we demonstrate that the monotonic equilibrium exists and is unique under
mild conditions. First, we want to understand the manager’s incentives in the first period.
Her expected discounted payoff at this point is
h h i i
ER log R1 f1 A1 (π) + δ · log R2 f2 A2 (φβ ) sm , s, β , α
 

where the expectation taken with respect to the returns of both periods. A1 (π) is the equilib-
rium allocation of AUM in the first period, which has a functional form similar to that of
A2 (φβ ) and β is β1 .
Hereafter, the focus of the paper shifts to the interactions of the first period. As a result,
in order to make our formulas more compact, the time subscript t is dropped, whenever this
does not create an ambiguity. Using the properties of the natural logarithm we simplify the
manager’s payoff maximisation problem in period 1 to
h i
max Er r + δ · λ · [φβ (r, sm ) · (uH − uL ) + uL ] sm , s, β , α (3.10)
β∈{0,1}

Therefore, the manager cares both about her returns in the first period r, but also on how
those affect her posterior reputation φβ (r, sm ). This reputation is important because it affects
the amount of AUM that the manager will manage to gather in the beginning of the second
period.
First, we want to offer a characterisation of the monotonic equilibrium.

Lemma 1 In any monotonic equilibrium the high and low type invest in their idiosyncratic
strategy if and only if
s ≥ h(sm ) and s ≥ l(sm ) , (3.11)

respectively. At the cut-off the manager should be indifferent between choosing to invest in
her idiosyncratic strategy (β = 0) or in the market (β = 1). Therefore, the expected utilities
3.3 Analysis 46

in the corresponding cases should be equal:

h i
Er a + δ · λ · [φ0 (r, sm ) · (uH − uL ) + uL ] s = h(sm ), α = H
h i
= Er m + δ · λ · [φ0 (sm ) · (uH − uL ) + uL ] sm

This implicitly defines h(sm ). Similarly:

h i
Er a + δ · λ · [φ0 (r, sm ) · (uH − uL ) + uL ] s = l(sm ), α = L
h i
= Er m + δ · λ · [φ0 (sm ) · (uH − uL ) + uL ] sm

which defines l(sm ).

This implies that the corresponding conditional expectations, E[r|s = h(sm ), α = H] and
E[r|s = h(sm ), α = L], are equal. That is

(1 − ψ) · H + ψ · h(sm ) = (1 − ψ) · L + ψ · l(sm )

and hence

1−ψ
l(sm ) − h(sm ) = · (H − L) (3.12)
ψ

Proof: In Appendix B.1. □

Hence the more confident the manager becomes on her alpha, the more likely she is to
use her idiosyncratic strategy, instead of the index tracking one. In addition, the fact that the
high type’s cutoff is lower captures the fact that a competent manager uses her idiosyncratic
investment strategy relatively more often.
Second, we want to calculate the manager’s posterior reputation after each investment
decision as a function of her performance.

Lemma 2 (Posteriors) In any monotonic equilibrium the manager’s posterior reputation in

the beginning of the second period, if she invested on her alpha β1 = 0 in the first, is
 ! −1
r−l(sm )(1+ψ)+Lψ
Φ √
 
1−π ν 1+ψ
 
φ0 (r, s ) = 1 +
m
· ρ(r) · !  , (3.13)
 
π r−h(sm )(1+ψ)+Hψ 
Φ

√
 
ν 1+ψ
3.3 Analysis 47

where
−2(H − L) r + H 2 − L2
!
ρ(r) = exp .
2ν2 ψ(1 + ψ)
On the other hand, if she invested in the market β = 1 then this becomes
 l(sm )−L)  −1
Φ

 1−π ν

φ1 (sm ) = 1 + ·  h(sm )−H   (3.14)
π Φ ν

We recall that r depends on the investment decision β.

Proof: In Appendix B.1. □

The investors form their posterior belief on the manager’s ability by observing her
investment decision β and the realised return r. Note that when using her idiosyncratic
investment strategy the manager’s performance r is generated by her alpha. Hence, in this
case the realisation r carries additional information on the manager’s ability. On the other
hand, when using the index tracking strategy r is equal to the market’s return m, which carries
no additional information on the manager’s ability. This is why φ0 is a function of r, but φ1
is not.
Using the above two lemmas, we prove the main result of this part.

Proposition 1 A monotonic equilibrium always exists. Moreover, a sufficient condition for it

to be unique is that
δ · λ · (H − L) ≤ ψ2 · ν2 (3.15)

Proof: In Appendix B.1. □

We believe that (3.15) is satisfied for a wide range of parametric specifications that
we would consider natural given the economic setting we study. This translates into two
requirements. First, that the difference between the ability of the two types is not too big.
Second, that the precision of the signal s is neither so small that it becomes irrelevant, nor so
big that the manager’s ex-ante ability α becomes irrelevant instead.

3.3.3 Results
Here, we present some important properties of the unique monotonic equilibrium. We assume
throughout that (3.15) holds. To maintain the notation as light as possible keep using φ0 (r, sm )
and φ1 (sm ) to refer to the equilibrium reputations, which are obtained after substituting the
corresponding values for h(sm ) and l(sm ).
3.3 Analysis 48

Proposition 2 (Point-wise dominance) There is a strict reputational benefit for the man-
ager from investing in her alpha, that is

φ0 (r, sm ) > φ1 (sm ), for all r, sm ∈ R. (3.16)

Proof: In Appendix B.1. □

We already know that in every monotonic equilibrium φ0 (r, sm ) is increasing in r, in other
words high performance is beneficial for the manager’s reputation. The proof demonstrates
the result by considering the worst case scenario for the manager β = 0. In the extreme
scenario where return approaches minus infinity her reputation is still greater than choose
β = 1. Hence the equilibrium difference between the cutoffs used by the high and low type is
such that the investors’ inference on the manager’s type relies relatively more on her choice
of strategy than on the subsequent performance of her fund.
This may seem counterintuitive at first, but it has a very simple explanation. In the
appendix we show that for a monotonic equilibrium to also be rational the difference between
the equilibrium cutoffs l(sm ) and h(sm ) cannot be too large. If that was the case, then a low
type would have to be so confident in order to invest in her alpha that a very bad performance,
under the low beta strategy, would be associated with a high type. An immediate consequence
of which would be that the manager’s reputation would be non-monotonic on her performance.
But those are exactly the type of equilibria that appear to be the less realistic.
The above claim is the most challenging one to verify in the data. This is because for each
fund we never observe the counter-factual, that is how the fund’s flow would look like if it
had chosen a lower, or higher beta strategy. Moreover, the simplifying assumption β ∈ {0, 1}
makes this result stronger than what an alternative model, where the two betas are closer
to each other, would give. Despite that, we can verify empirically that to a certain extent a
low beta strategy creates enough signalling value to counter the effect of a low subsequent
performance.
As a direct consequence of point-wise dominance, we can now get the following inter-
esting proposition, which characterises the effect of the manager’s career concerns on her
investment behaviour.

Proposition 3 (Investment Behaviour) The equilibrium cutoffs h(sm ) and l(sm ) are decreas-
ing in the discount factor δ. Moreover, there is overinvestment in the manager’s idiosyncratic
project, that is
h(sm ) ≤ c(H, sm ) and l(sm ) ≤ c(L, sm ). (3.17)

Proof: In Appendix B.1. □

3.3 Analysis 49

The proof is a simple application of the implicit function theorem on equation (B.17),
the solution of which is shown in the proof of Proposition 1 to be h(sm ). The corresponding
result for l(sm ) is obtained by invoking the fact that in every monotonic equilibrium those
two cutoffs are connected through a linear relationship, which was again demonstrated in the
above proof.
We use the term “over-investment" to describe the fact that the manager invests in her
idiosyncratic strategy more often than in the absence of career concerns. In other words, over-
investment exists when the manager “lower her standards" with regards to her private signal,
i.e. she lowers the confidence level required for her to choose the idiosyncratic investment.
Note that the manager’s optimal cutoff, in the absence of career concerns, corresponds to that
already derived from for the second period in (3.8). This is because it is generated by the
inefficiency in the investment decision that the manager’s career concerns create, which is
connected to the underlying parameter δ.
The above proposition demonstrates that there is a bias towards active management in
the financial intermediation industry, which is due to its inherent informational asymmetries.
To be more precise, we expect managers to get on average less exposure to the market
than what would maximise the fund’s expected return. Moreover, this action is associated
with competence and it is rewarded with an increase in the fund’s AUM. Hence, our model
provides a theoretical justification for this well documented fact.
Next, we want to see how this bias depends on the unobserved, to the econometricians,
market signal sm and the manager’s prior reputation π.

Proposition 4 The cutoffs h(sm ) and l(sm ) are increasing in the market signal sm . In addition,
there exist lower bounds s̄m and π̄ such that for every (sm , π) such that sm ≥ s̄m and π ≥ π̄
both cutoffs h(sm ) and l(sm ) are increasing functions of the manager’s prior reputation π.

Proof: The proof of the first statement is similar to that of Proposition 3. The proof of the
second follows from Lemma 7, which can be found in Appendix B.1. □
The first statement is a very intuitive result. The better the manager expects the market
portfolio to perform, the more eager she becomes to invest in it, which translates into higher
equilibrium cutoffs.
The crucial implication of the proposition’s second statement is that the bias created from
the signalling value, of investing in the idiosyncratic strategy, is decreasing in the manager’s
prior reputation. This is because the equilibrium cutoffs are bounded above by the expected
return maximising cutoff c(α, sm ), hence the more π increases the closer they get to it.
A caveat of this result is that it only holds for a manager that is already relatively
recognised in the market, in particular it is shown in the appendix that we need at least
3.3 Analysis 50

π > 1/2. Intuitively, the closer the prior is to either zero or one, the less it is affected by the
actions of the manager. To make this more concrete, think of the extreme case where π → 1,
in which case it is very difficult for the investors to change their opinion about her ability, as
they already know it with almost total certainty. Hence, there is a corresponding result that
can be stated for managers of very low reputation. Even though in our model we allow for
funds of small size to stay active, in reality most of them would either shut down, or would
not even be reported in most datasets, hence we focus just on funds with reputation greater
than a 1/2. 9 .
Another interesting feature of the presented specification is that it provides a better
understanding on how the sensitivity of the fund’s asset flows to its performance depend on
the market conditions. Let φi (ri , sm , βi ) stand for the manager’s reputation in either of the two
cases and call dφi /dri its sensitivity with respect to her performance.

Proposition 5 The conditional probability that a manager has invested in the market portfo-
lio P(βit = 1 | mt ) is increasing in its contemporaneous performance mt .
In addition, for a sufficiently reputable manager the conditional expected sensitivity of
the manager’s reputation with respect to her performance, i.e. E sm [dφi /dri | mt ], is decreasing
in mt .

Proof: In Appendix B.1. □

When markets are expected to perform well, the manager’s direct incentives outweigh
those of career concerns. Hence we know from Proposition 4 that she is more likely to give
up the reputational benefit of following a low beta strategy. But high beta strategies carry no
information with respect to the manager’s ability. Hence, even though as noted in Proposition
2 investing in low beta always has a reputational benefit, this benefit is less pronounced in
good markets. Therefore investors are expected to rely more on a manager’s performance to
update their belief about the ability of the manager, when markets are bear than when markets
are bull. This result is also supported by the empirical evidence we provide in section 3.4.

3.3.4 Discussion on the competition between funds

It follows from the previous discussion that managers will be judged much more strictly on
their performance in bear markets than in bull markets. This in turn has some implications
for the relative ranking of the various funds with respect to their reputation, or equivalently
their AUM.
9
Despite that we hope to test empirically if we can obtain a corresponding result for the flows of small
funds.
3.3 Analysis 51

To study this we extend our model by allowing a second manager to operate in the market.
We formally define the investor’s preference shock in this case and derive the corresponding
AUMs of the two funds in Appendix B.2. In fact, the whole analysis of this paper and all
our results remain unchanged with the addition of a second manager. The reason is that the
manager’s utility is such that it is only a function φβ (r, sm ) · (uH − uL ) + uL and is independent
of the number of managers that exist in the model10 .
Our main aim is to study the likelihood of a change in the rank of managers, in terms of
investors’ beliefs about their ability and relate that to the market conditions. In what follows,
we explain why this effect is not monotonic in mt 11 .
Let P(i, j | sm ) = P(βfund 1 = i, βfund 2 = j | sm ). In the Appendix it is shown that:

P(φ1 > φ2 | sm ) = P(φ10 > φ21 | sm ) P(0, 1 | sm ) + P(φ10 > φ20 | sm ) P(0, 0 | sm ), (3.18)

What this equation suggests is that the ranks of managers can change through two possible
scenarios. In the first scenario, with probability P(0, 1 | sm ), one of the two managers invests
in his idiosyncratic portfolio and the other follows the market. This probability approaches
zero for both very large and very small sm , as then both managers invest in the market or
both invest in their own project. In turn, this makes the first term of the right hand side of
the equation (3.18) hump-shaped in sm . Under this scenario, manager 1 has a reputational
benefit from choosing β = 0 (see Proposition 2) which then makes it possible for his ex-post
reputation to be higher than that of manager 2 (despite his initial disadvantage, in terms of
the priors π1 , π2 ); clearly the smaller the distance between their prior reputations, π2 − π1 , the
larger this likelihood will be.
In the second scenario, with probability P(0, 0 | sm ) both managers invest in their own
project and manager one receives a much higher return than the other, thus overcoming the
effect of the initial prior reputations; in other words, since π1 < π2 , in order for the posterior
reputations to have the opposite order, what needs to happen is that the realised return of
manager 1 is much higher than that of 2. This is clearly not possible if they both invest in
the market. However, when they both invest in their idiosyncratic project this can happen
either because one is luckier than the other, or simply because manager one has high skill
and manager two has low skill. This scenario is less likely to occur as the market conditions
get better since P(0, 0 | sm ) is decreasing in sm , as we can see from Proposition 5. Moreover,
we can get the following remark:
10
In particular, equation (39) and thus the determination of the cutoffs l and h will remain the same.
11
Note, we always condition on sm as we know that all investors observe this market signal.
3.3 Analysis 52

Remark 1 The likelihood of a change in the ranks of managers is higher in a very bad
market, than in a very good market. That is:

lim P(φ1 > φ2 | sm ) > mlim P(φ1 > φ2 | sm ) (3.19)

sm →−∞ s →+∞

The proof of this remark is quite simple. As the market becomes really good, the probability
of a manager investing in his own project goes to zero, and hence from (4.20) we see that the
probability of a rank change will tend to zero. In contrast, for a very negative market signal,
this probability is strictly negative, since P(0, 0|sm ) = 1 and P(φ10 > φ20 | sm ) > 012 ;
From the above analysis, it is clear that the overall effect does not have to be monotonic
in sm . Hence we use simulations to illustrate the properties of the probability of interest
as a function of the market signal, confirming also the observation in the aforementioned
remark13 .

On the y-axis we have the probability of change in rank, and on the x-axis the correspond-
ing market signal. As it can been seen from the graph the total effect is hump-shaped in sm , it
is decreasing as the market signal becomes relatively large and also it is smaller when market
conditions are good compared to when they are bad.
In the next section, we find empirical evidence supporting our results. This is done
by constructing divisions in which each fund is allocated in accordance with their AUM.
Subsequently, we calculate the proportion of funds that changed division from the beginning
12
This probability is always strictly positive, since we know that φ10 (r1 , sm ) → 1 as r1 → +∞ and sm → −∞,
or intuitively the return of manager 1 may be much larger than that of manager 2 when they invest in their own
projects (either because one has high skill and the other has low or because one is just luckier than the other)
and hence this can always lead to a change of ranks.
13
For this simulation we set the parameters as: π1 = 0.6,π2 = 0.601, αH = 0.16, αL = 0.1,σ = ν = 0.35,
f = f 2 = 0.01, σm νm = 0.25, λ1 = λ2 = 0.8 and δ = 0.5.
1
3.3 Analysis 53

of each period to its end. Approximately, this measures the probability to which the above
proposition refers.
3.4 Empirics 54

3.4 Empirics
3.4.1 Data
The data used in this study comes from the Morningstar CISDM database. The time span of
our sample is from January 1994 to December 2015. To mitigate survivorship bias we include
defunct funds in the sample. We have created a larger group of strategies to accumulate the
Morningstar’s categories. All fund returns have been converted to USD (U.S dollars) using
the exchange rates of each period separately. Observations of performance or assets under
management, with more than 30 missing values, have been deleted. All observations are
monthly. Our main variable of interest is flows, which gives the proportional in and out flows
of the fund with respect to its assets under management. For the market return we consider
the S&P 500 and as fund excess returns, the difference of the fund’s return with the market.
In particular, we use the corresponding Fama-French market factor obtained from the WRDS
(or from Kenneth French’s website at Darmouth). We also examine the relationship of alpha
and beta of a fund as well as their relationship to the flows.

3.4.2 Empirical Evidence

The purpose of this section is to empirically test some of the assumptions as well as the
results of our model and show that our model can be empirically supported by data. For
simplicity we will use CAPM alpha and beta throughout this section, calculated using a 32
month period (which we will define in this section as one period)14 . Moreover we will refer
to the log of the assets of a fund lagged by one period, simply as the fund’s assets. First of
all, our model assumes that investors get a signal about the market (sm ) before everyone else
does. This would imply some form of market-timing 15 . We first run the following panel
regression, with fixed effects:

Betat = λ0 + λ1 rm,t + λ2 Assetst−1 + λ3 Aget + di + εt

where rm,t is the period market return (described above) and di corresponds to the fixed effects
dummy (although the subscript i for the fund has been suppressed in the rest of the variables).
The results are shown below:
The positive and significant coefficient in front of the market return supports our model
assumption (as well as with the prediction of Proposition 3 about over-investment), in the
14
We have also performed robustness check using the 4-factor alphas and betas.
15
In the empirical literature there have been studies both in favour Chen and Liang (2007) as well as against
this finding Franzoni and Schmalz (2017).
3.4 Empirics 55

Table 3.1 Estimation results : Beta on Market Return.

The baseline model we run is summarised by beta ∼ rm + assets + controls.
Variable Coefficient (Std. Err.)
rm 0.03256 ∗ (0.01372)
assets 0.01467∗∗ (0.00508)
age 0.00502 ∗∗ (0.00144)
Intercept 0.02430 (0.08400)
Significance levels : † : 10% ∗ : 5% ∗∗ : 1%

sense that it indicates that when markets are bull, it is more likely that managers choose to get
higher exposure to the market. This is consistent with what we would observe if managers
had market-timing abilities.
Another result of our model is that in equilibrium l > h. Given the definition of the cutoff
equilibrium strategies described in (5), this leads to: P(β = 1|L) > P(β = 1|H). If this is the
case, we would expect to see in the data that funds with higher alpha, have on average lower
betas, i.e they choose to invest on their idiosyncratic project since they benefit both from
potential higher returns thanks to their superior alpha as well as from signalling their skill.
Indeed this is the case. We are using the following cross-sectional baseline model, for the
last date in our data, December 201516 :

Alphat = λ0 + λ1 Betat + λ2 Assetst−1 + Λ3 Controls + εt ,

where controls include the age and the strategy of the fund. As shown in Table 2 the
coefficient of interest is negative, suggesting that more skilled managers pick a high beta less
often.
Table 3.2 Cross-sectional Regression of Alphas on Betas and controls, t = 12/2015.The
baseline model we run is summarised by alpha ∼ beta + assets + controls.

Variable Coefficient (Std. Err.)

beta -0.00958∗∗ (0.00085)
assets 0.00006 (0.00016)
age 0.00001 (0.00005)
strategy 0.00003 (0.00009)
Intercept 0.00130 (0.00284)
Significance levels : † : 10% ∗ : 5% ∗∗ : 1%

Even more importantly, we want to test the second implication of Proposition 5. That is,
we want to test whether the data suggest that the sensitivity of flows to performance is higher
16
We only include funds that report US dollars as their base currency.
3.4 Empirics 56

when beta is 0, or consequently is higher when markets are bear than when they are bull. We
will measure the fund flows, as in Sirri and Tufano (1998):

T NAt − (1 + Rt )T NAt−1
Flowst =
T NAt−1

where TNA is the total net assets and R is the return of the fund. We will use the simple
return of the fund, ri , as the measure of performance, as in Clifford et al. (2013). We think
that this is the most appropriate measure of performance to test the predictions of our model.
The following two tables17 verify the above finding, and support our predictions18 . First
regression is a cross-sectional one for December 2015.

AvFlowst = λ1 ri,t · Bigbetat + λ2 Assetst−1 + Λ3 Controls + εt

where AvFlows is the average flows of the previous period, Bigbeta = 1{β≥0.3} , ri,t is the fund’s
period return and controls include the age, the strategy and the bigbeta dummy of the fund
(the intercept λ0 is just suppressed in the above equation).

Table 3.3 Flows on Performance and Beta, t = 12/2015

Variable Coefficient (Std. Err.)

ri ·Bigbeta -0.12510∗∗ (0.03433)
Bigbeta 0.01204 (0.01522)
assets -0.01437∗∗ (0.00389)
strategy 0.00352 (0.00231)
age -0.00133 (0.00120)
Intercept 0.25846∗∗ (0.06906)
Significance levels : † : 10% ∗ : 5% ∗∗ : 1%

The second table we are presenting is a panel regression with fixed effects, where we
regress flows on the interaction of annual fund’s performance and market return, including
the usual controls. That is, our baseline model is:

AvFlowst = λ1 ri,t · rm,t + λ2 Assetst−1 + Λ3 Controls + di + εt

where controls include the fund’s beta and the period return of the market and of the fund
itself.
17
Since the funds selected in our model, are only between β = {0, 1}, thus making the implicit assumption
that there is no short-selling of the market, we will exclude all observation with negative β, which are less than
15% of our sample.
18
This result was only recently documented empirically in a paper by Franzoni and Schmalz (2013).
3.4 Empirics 57

Table 3.4 Flows on the interaction of Fund Performance and Market Return

Variable Coefficient (Std. Err.)

ri · rm -0.15297∗∗ (0.03697)
beta 0.00423 (0.00648)
ri 0.07538∗∗ (0.02036)
rm 0.02828∗∗ (0.00955)
assets -0.02718∗∗ (0.00224)
Intercept 0.47264∗∗ (0.03964)
Significance levels : † : 10% ∗ : 5% ∗∗ : 1%

In both cases we can see that the coefficient of interest is significantly negative. The
interpretation of these two regressions is the following: the first one shows that funds with
higher beta are not judged so much on their performance; that is the higher the beta, the less
important the flow performance relationship. On the other hand, the second table supports
the statement that the sensitivity of fund flows to performance depends on the state of the
market and more specifically it is decreasing on the market return. Under the predictions of
our model, these two results are almost equivalent, and we indeed get that the coefficient in
both cases is negative and significant, thus supporting one of our main results as well.
Finally, we want to provide some empirical evidence relevant to the discussion on
the competition of funds. Namely, we find support for Remark 1, by demonstrating that
the probability of changes in the ranking of funds, with respect to their AUM, is higher
under adverse market conditions. To achieve this a new variable is constructed. First, the
sample is separated in periods of eight months, so that we have thirty periods in total. For
each one, seventy divisions (clusters of funds) are created. Funds are allocated in those
divisions according to the size of their AUM at the end of each period19 . Then we define
divjumpassetUSDt as the percentage of funds that changed division from the beginning to
the end of period t. We are careful to only compare funds that were active during the whole
duration of each period. Also, we only consider the US universe of funds to avoid introducing
noise created from fluctuations in the exchange rates.
19
Our methodology closely follows previous work done by Marathe and Shawky (1999) and Nguyen-Thi-
Thanh (2010).
3.5 Extension: Unobservable Investment Decision 58

On the y-axis we have our constructed measure of changes between divisions divjumpas-
setUSDt , and on the x-axis the corresponding total return of the market portfolio during the
same period. As it can been seen from the graph there appears to be a negative relationship
between the two, which is also statistically significant. Note that this is just an indication
of the relationship between the rank of funds and the market conditions, under a simple
linear regression, and thus it does not capture any second order effects (or a hump-shaped
relationship). Hence, our prediction in Remark 1 is only supported by weak evidence, but we
believe that there is much more to explore in this direction in the future.

3.5 Extension: Unobservable Investment Decision

In this section, we want to extend our model, and investigate the equilibrium where the
investment decision of the fund managers cannot be observed by the investors. In this case,
investors use the return of the fund managers’ to both update their beliefs about managers
skill and to also understand whether or not they invested in their own project. In reality, it
is indeed the case that investors do not know exactly the exposure of a fund manager to the
systematic risk. Instead they use a history of data of the fund return’s comovement with the
market return to infer the fund’s statistical beta. Since the model we are examining here is
static, the assumption in this section is that this inference is only made based on the proximity
of the market return to the fund’s return.
The model considers only one period and it remains the same as before, apart from a few
changes outlined below. Firstly, an additional error ϵ has been introduced in order to make
3.5 Extension: Unobservable Investment Decision 59

the manager’s choice of investment unobservable by the investors. (Note, that without this
tracking error, investors could perfectly observe the decision of managers based on whether
or not r = m.) Hence our model becomes:

r = (1 − β) a + β (m + ϵ)
a ∼ N(α, σ2 )
(3.20)
m ∼ N(µ , σ2m )
ϵ ∼ N(0 , σ2ϵ )

The manager’s performance r is a weight average of the return of her idiosyncratic

strategy a and that of the market m, and as before we study only the simple binary case where
β ∈ {0, 1}. The rest of the notation and ideas remain unchanged.
The posterior distribution of r, conditional on (α, β, s, sm ) is given by
 
r | α, β, s, sm ∼ N r̄(α, β, s, sm ), σ̄2 (β)
r̄(α, β, s, sm ) ≡ (1 − β)[(1 − ψ)α + ψs]
(3.21)
+ β[(1 − ψm )µ + ψm sm ]
σ̄2 (β) ≡ (1 − β)2 ψν2 + β2 (ψm νm2 + σ2ϵ )

Our goal is to study whether a monotonic cutoff equilibrium (introduced in the previous
sections) exists under this alternative assumption. We believe that only such an equilibrium
would be interesting and realistic to serve for further study. We move on to find a closed-form
expression for the ex-post reputation φ, which is given by the following lemma.

Lemma 3 The manager’s posterior reputation is given by

!−1
1 − π ρ r, L, l(sm )
φ(r, m, s ) = 1 +
m

, (3.22)
π ρ r, H, h(sm )

where l(sm ) h(sm ) from lemma 1, we have

1−ψ
l(sm ) − h(sm ) = (H − L), (3.23)
ψ

and
!
  ϕ √ r−α  
 c − α  ϕ r−m
 r − c(1 + ψ) + αψ  ν ψ(1+ψ) σϵ
ρ(r, α, c) = Φ   × p + Φ , (3.24)
ν 1+ψ ν ψ(1 + ψ) ν σϵ
p
3.6 Conclusions 60

Proof: In Appendix B.3. □ Using the above lemma, we can now see whether this model
can provide us with an equilibrium where the reputation φ(r, m, sm ) is increasing in r. In fact,
we get the following proposition:

Proposition 6 A monotonic equilibrium under unobservable beta does not exist.

Proof: In Appendix B.3. □

What this proposition shows is that the reputation φ(r, m, sm ) cannot always be increasing
in r under the assumption that investors do not observe the investment choices. That is to
say that the assumption of unobservable investment choice under a static setting can lead
us to counterintuitive equilibrium properties. We believe that in future research it could be
interesting to study this realistic case under a dynamic setting where the inference of beta
will be indeed based on the comovement of the market return with the fund’s return.

3.6 Conclusions
The role of financial intermediaries and their characteristics has been greatly explored in
the recent empirical literature. In this article, we have developed a theoretical model that
describes how the strategic investment decisions of fund managers is influenced by their
career concerns. To sum up our argument, these managers will tend to over-invest in market
neutral strategies as a way to signal their ability. Moreover, we have described how managers’
reputation depends on the market conditions; in particular, we find that the sensitivity of
flows to performance is higher in bear markets than in bull markets and we discuss the
competition between funds, measured by the changes in their rankings, as a function of
the market conditions. Our model entails predictions about some directly observable fund
characteristics such as their size and fees, as well as some indirectly observable quantities
such as their reputation or their investment behavior depending on their signals. In our
empirical section, we have managed to find support for many of the assumptions as well as
predictions of our model. Moreover, we have extended our model to include the case when
the manager’s investment decision is not observable by the investors.
There are many ways forward with this research. The results of this model do not depend
on the specific factor which funds use when they are tracking an index; one, may try to
apply the same logic in funds that use factors other than the market return and test the
corresponding empirical predictions. Also, using a slightly different interpretation of the
investor’s decision between allocating funds to a manager or to the market, one could think of
an investor choosing between an active and a passive fund and use the closed form solution
3.6 Conclusions 61

for the fund’s size, to see how the relative (total) size of the passive and active funds, depends
on the market conditions.
Bibliography

Anthropelos, M. (2017), ‘The effect of market power on risk-sharing’, Mathematics and

Financial Economics 11, 323–368.

Anthropelos, M. and Kardaras, C. (2017), ‘Equilibrium in risk-sharing games’, Finance and

Stochastics 21(3), 815–865.

Anthropelos, M. and Žitković, G. (2010), ‘On agent’s agreement and partial-equilibrium

pricing in incomplete markets’, Mathematical Finance 20(3), 411–446.

Babus, A. (2016), ‘The formation of financial networks’, RAND Journal of Economics

47, 239–272.

Babus, A. and Hu, T.-W. (2016), Endogenous intermediation in over-the-counter markets.

Forthcoming in Journal of Financial Economics.

Back, K. (1992), ‘Insider trading in continuous time’, The Review of Financial Studies

5(3), 387–409.

Back, K., Cao, C. and Willard, G. (2000), ‘Imperfect competition among informed traders’,

The Journal of Finance 55(5), 2117–2155.

Bibliography 63

Barrieu, P. and El Karoui, N. (2005), ‘Inf-convolution of risk measures and optimal risk

transfer’, Finance and Stochastics 9(2), 269–298.

Berk, J. B. and Green, R. C. (2004), ‘Mutual fund flows and performance in rational markets’,

Journal of political economy 112(6), 1269–1295.

Blume, M. and Keim, D. (2012), Institutional investors and stock market liquidity: Trends

and relationships. Working Paper.

Borch, K. (1962), ‘Equilibrium in a re-insurance market’, Econometrica 30, 424–444.

Brunnermeier, M. and Pedersen, L. (2005), ‘Predatory trading’, Journal of Finance 60, 1825–

1863.

Buhlmann, H. (1984), ‘The general economic principle premium’, Astin Bulletin 14, 13–21.

Chen, Y. (2015), ‘Career concerns and excessive risk taking’, Journal of Economics &

Management Strategy 24(1), 110–130.

Chen, Y. and Liang, B. (2007), ‘Do market timing hedge funds time the market?’, Journal of

Financial and Quantitative Analysis 42(4), 827–856.

Chevalier, J. and Ellison, G. (1997), ‘Risk taking by mutual funds as a response to incentives’,

Journal of Political Economy 105(6), 1167–1200.

D., D., Scheicher, M. and Vuillemey, G. (2015), ‘Central clearing and collateral demand’,

Journal of Financial Economics 116, 237–256.

Bibliography 64

Dasgupta, A. and Prat, A. (2008), ‘Information aggregation in financial markets with career

concerns’, Journal of Economic Theory 143(1), 83–113.

Duffie, D., Gârleanu, N. and Pedersen, L. (2007), ‘Valuation in over-the-counter markets’,

The Review of Financial Studies 20(6), 1865–1900.

Franzoni, F. and Schmalz, M. C. (2017), ‘Fund flows and market states’, The Review of

Financial Studies 30(8), 2621–2673.

Gibson, S., Singh, R. and Yerramilli, V. (2003), ‘The effect of decimalization on the compo-

nents of the bid-ask spread’, Journal of Financial Intermediation 12, 121–148.

Guerrieri, V. and Kondor, P. (2012), ‘Fund managers, career concerns, and asset price

volatility’, The American Economic Review 102(5), 1986–2017.

Hameed, A., Lof, M. and Suominen, M. (2017), Slow trading and stock return predictability.

Working paper, available at SSRN: https://ssrn.com/abstract=2671237.

Hendershott, T. and Madhavan, A. (2015), ‘Click or call? auction versus search in the

over-the-counter market’, Journal of Finance 70, 419–447.

Hu, P., Kale, J. R., Pagani, M. and Subramanian, A. (2011), ‘Fund flows, performance,

managerial career concerns, and risk taking’, Management Science 57(4), 628–646.

Huang, J. C., Wei, K. D. and Yan, H. (2012), ‘Investor learning and mutual fund flows’.

Ippolito, R. A. (1992), ‘Consumer reaction to measures of poor quality: Evidence from the

mutual fund industry’, The Journal of Law and Economics 35(1), 45–70.
Bibliography 65

Jouini, E., Schachermayer, W. and Touzi, N. (2008), ‘Optimal risk sharing for law invariant

monetary utility functions’, Mathematical Finance 18(2), 269–292.

Keim, D. and Madhavan, M. (1995), ‘The anatomy of the trading process: Empirical evidence

on the behavior of institutional traders’, Journal of Financial Economics 37, 371–398.

Keim, D. and Madhavan, M. (1996), ‘The upstairs markets for large-block transactions.

analyses and measurement of price effects’, Review of Financial Studies 9, 1–39.

Klemperer, P. and Meyer, M. (1989), ‘Supply function equilibria in oligopoly under uncer-

tainty’, Econometrica 57(6), 1243–1277.

Kyle, A. (1989), ‘Informed speculation with imperfect competition’, Review of Economic

Studies 56(3), 317–55.

Kyle, A., Obizhaeva, A. and Wang, Y. (2018), ‘Smooth trading with overconfidence and

market power’, The Review of Economic Studies 85(1), 611–662.

Liu, H. and Wang, Y. (2016), ‘Market making with asymmetric information and inventory

risk’, Journal of Economic Theory 163, 73–109.

Ma, L. (2013), ‘Mutual fund flows and performance: A survey of empirical findings’.

Madhavan, M. and Cheng, M. (1997), ‘In search of liquidity: Block trades in the upstairs

and downstairs markets’, Review of Financial Studies 10, 175–203.

Magill, M. and Quinzii, M. (2002), Theory of incomplete markets, Vol. 1, Mit press.
Bibliography 66

Malamud, S. and Rostek, M. (2017), ‘Decentralized exchange’, Americal Economic Review

11, 3320–3362.

Malliaris, S. G. and Yan, H. (2015), ‘Reputation concerns and slow-moving capital’.

Marathe, A. and Shawky, H. A. (1999), ‘Categorizing mutual funds using clusters’, Advances

in Quantitative analysis of Finance and Accounting 7(1), 199–204.

Nguyen-Thi-Thanh, H. (2010), ‘On the consistency of performance measures for hedge

funds’, Journal of Performance Measurement 14(2), 1–16.

Robertson, S. (2017), ‘Pricing for large positions in contingent claims’, Mathematical

Finance 27(3), 746–778.

Rostek, M. and Weretka, M. (2008), Thin markets, in ‘The New Palgrave Dictionary of

Economics Online’, Eds. S. N. Durlauf and L. E. Blume., Palgrave Macmillan, pp. 307–

336.

Rostek, M. and Weretka, M. (2012), ‘Price inference in small markets’, Econometrica

80(2), 687–711.

Rostek, M. and Weretka, M. (2015), ‘Dynamic thin markets’, Review of Financial Studies

28, 2946–2992.

Sirri, E. R. and Tufano, P. (1998), ‘Costly search and mutual fund flows’, The journal of

finance 53(5), 1589–1622.

Bibliography 67

Vayanos, D. (1999), ‘Strategic trading and welfare in a dynamic market’, Review of Economic

Studies 66(2), 219–54.

Vives, X. (2011), ‘Strategic supply function competition with private information’, Econo-

metrica 79, 1919–1966.

Wahal, S. and Wang, A. Y. (2011), ‘Competition among mutual funds’, Journal of Financial

Economics 99(1), 40–59.

Warther, V. A. (1995), ‘Aggregate mutual fund flows and security returns’, Journal of

financial economics 39(2), 209–235.

Weretka, M. (2011), ‘Endogenous market power’, Journal of Economic Theory 146(6), 2281

– 2306.

Zawadowski, A. (2013), ‘Entangled financial systems’, Review of Financial Studies

26(1), 1291–1323.
Appendix A

Appendix on chapter 2

A.1 Appendix: Omitted Proofs

Proof: [Proof of theorem 2.3.4]
Let us start with the case where both conditions (2.18) and (2.15) hold. Proposition 2.3.6,
together under the validity of (2.16) which is equivalent to (2.18), shows that there exists an
extreme linear Nash equilibrium. This is, in fact, unique over extreme linear Nash equilibria;
indeed, note that (2.18) immediately implies that βk > 1. Let us assume that trader k ∈ I is
the only trader with beta greater than one, i.e., that βi ≤ 1 for all i ∈ I \ {k}. Let (θi∗ )i∈I be any
linear noncompetitive equilibrium in terms of Definition 2.3.1. According to (2.9), βi ≤ 1
implies that θi∗ ≤ δi (1 + βi )+ , for all i ∈ I \ {k}. But then,

1 X θ∗
βk ≥ 1 + δi (1 + βi )+ ≥ 1 + −k .
δk i∈I\{k} δk

By (2.9) again, it follows that θk∗ = ∞, and applying (2.9) once again, we have θi∗ = δi (1 + βi )+ ,
for all i ∈ I \ {k}, which establishes uniqueness of the extreme Nash equilibrium over all
possible linear Nash equilibria of Definition 2.3.1.
Having dealt with the case of extreme equilibrium, until the end of the proof we shall
assume that (2.15) holds but (2.18) fails. Without loss of generality, let trader 0 ∈ I have the
maximal pre-transaction beta: βi ≤ β0 for all i ∈ I \ {0}. In view of Lemma 2.3.5, we then
have that, necessarily,
1 X
− 1 < β0 < 1 + δi (1 + βi )+ . (A.1)
δ0 i∈I\{0}

Define the set

J := {i ∈ I \ {0} | − 1 < βi ≤ 1} .
A.1 Appendix: Omitted Proofs 69

The set J0 := J ∪ {0} contains all traders that will eventually submit demand functions
with non-zero elasticity. Note that (A.1) implies that J , ∅; indeed, if J = ∅, then β0 =
1 − i∈I\{0} βi > 1, and (A.1) would fail, since the quantity at the right-hand side would equal
P

1.
A Nash equilibrium exists if and only if θi∗ = 0 holds for all i ∈ I \ J0 , while

θ∗I − θi∗ θi∗

!
2+ = 1 + βi , ∀i ∈ J,
δi θ∗I

following from (2.17). Given θ∗I > 0, θi∗ for i ∈ J satisfies the quadratic equation

1 ∗2
(θi ) − δi + θ∗I /2 θi∗ + δi (1 + βi )θ∗I /2 = 0,


∀i ∈ J. (A.2)
2
 2
The discriminant is equal to δi + θ∗I /2 − δi (1 + βi )θ∗I , which, since −1 < βi ≤ 1, is
always (regardless
q of the value of θ∗I ) non-negative. The two roots of equation (A.2) are
2
δi + θ∗I /2 ± δi + θ∗I /2 − δi (1 + βi )θ∗I . Note that since
r r
 2  2
δi + θ∗I /2 + δi + θ∗I /2 − δi (1 + βi )θ∗I ≥ δi + θ∗I /2 + δi + θ∗I /2 − 2δi θ∗I

= δi + θ∗I /2 + |θ∗I /2 − δi | ≥ θ∗I ,

and θ0∗ has to be strictly positive, it holds that θi∗ < θ∗I for each i ∈ J. Hence, the only root that
is acceptable, i.e., the only nonnegative root is
r
 2
θi∗ = δi + θ∗I /2 − δi + θ∗I /2 − δi (1 + βi )θ∗I , ∀i ∈ J.

(Recall that our Definition of noncompetitive equilibrium considers linear demand functions
with nonpositive slopes.) In other words, and upon defining the function ϕi : (0, ∞) 7→ R via
q
ϕi (x) := δi + x/2 − (δi + x/2)2 − δi (1 + βi )x, x > 0,

we should have θi∗ = ϕi (θ∗I ) for all i ∈ J. The next result gives some necessary properties on
ϕi for i ∈ J.
□

Lemma A.1.1 Let i ∈ J. Then, ϕi (0+) = 0, ϕ′i (0+) = (1 + βi )/2. Furthermore, ϕi is concave,
nondecreasing, and such that ϕi (∞) = δi (1 + βi ).
A.1 Appendix: Omitted Proofs 70

Proof: The fact that ϕi (0+) = 0 is immediate. In the special case βi = 1, we have
ϕi (x) = δi + x/2 − |x/2 − δi | = x ∧ (2δi ) for x > 0, and the result is trivial. When −1 < βi < 1,
ϕi is twice continuously differentiable, and an easy calculation gives

1 x/2 − δi βi
ϕ′i (x) = − q , x > 0,
2
2 (δi + x/2)2 − δi (1 + βi )x

from which it immediately follows that ϕ′i (0+) = (1 + βi )/2. Furthermore, another easy
calculation gives
 
−1 + (x/2 − δi βi )2 / (δi + x/2)2 − δi (1 + βi )x
ϕ′′i (x) = q , x > 0.
2 (δi + x/2) − δi (1 + βi )x
2

Therefore, ϕ′′i (x) < 0 for all x > 0 is equivalent to (x/2 − δi βi )2 < (δi + x/2)2 − δi (1 + βi )x for
all x > 0. Calculating the squares and cancelling terms, we obtain δ2i β2i < δ2i , which is true
since −1 < βi < 1. Therefore, ϕi is concave. Continuing, a straightforward calculation gives
 
x
q (x/2)2 − (δi + x/2)2 − δi (1 + βi )x
− (δi + x/2)2 − δi (1 + βi )x = q
2
x/2 + (δi + x/2)2 − δi (1 + βi )x
−δ2i + δi βi x
= q ,
x/2 + (δi + x/2) − δi (1 + βi )x
2

which, as x → ∞, has limit δi βi . Therefore, ϕi (∞) = δi (1 + βi ) > 0. Since ϕi (0) = 0 <

δi (1 + βi ) = ϕi (∞) and ϕi is concave, we conclude that it is nondecrasing. □
Regarding trader 0 ∈ I, since β0 > −1, in equilibrium we should have

θ∗I − θ0∗ θ0∗

!
2+ = 1 + β0 .
δ0 θ∗I

Note that θ∗I − θ0∗ = θi∗ = ϕi (θ∗I ). Therefore, upon defining

P P
i∈J i∈J

X
σ(x) := ϕi (x), x > 0,
i∈J

we should have
σ(θ∗I ) θ0∗
!
2+ = 1 + β0 ,
δ0 θ∗I
A.1 Appendix: Omitted Proofs 71

which immediately gives

(1 + β0 ) δ0 ∗
θ0∗ = θ,
2δ0 + σ(θ∗I ) I
Hence, in equilibrium, the following equation should hold for θ∗I > 0:

(1 + β0 ) δ0 ∗
θ + σ(θ∗I ) = θ∗I .
2δ0 + σ(θ∗I ) I

In other words, at equilibrium θ∗I should solve the equation

(1 + β0 ) δ0 σ(x)
+ = 1, x > 0. (A.3)
2δ0 + σ(x) x

By Lemma A.1.1, it follows that the left-hand-side of equation (A.3) is decreasing in x > 0.
Its limit at x = 0+ is equal to

1 + β0 X 1 + βi |J0 | 1 X
+ = + βi .
2 i∈J
2 2 2 i∈J 0

Since |J0 | ≥ 2 (recall that J , ∅) and i∈J0 βi ≥ 1 (by definition of J and the fact that βI = 1),
P

the above limit is strictly greater than one. It follows that (A.3) will have a (necessarily
unique) solution if and only if the limit as x → ∞ of the left-hand-side of (A.3) is strictly
less than one. In other words, and since σ(∞) = i∈J (1 + βi ) δi , it should hold that
P

X
(1 + β0 ) δ0 < 2δ0 + σ(∞) = 2δ0 + (1 + βi ) δi ,
i∈J

which is exactly (A.1).

The above discussion implies that a unique Nash equilibrium exists under the validity of
(2.15) and failure of (2.16), completing the proof of Theorem 2.3.4.
Appendix B

Appendix on chapter 3

B.1 Appendix: Omitted Proofs

Proof: [Proof of Lemma 1] Using (3.10) it is easy to argue that both idiosyncratic and
index tracking strategies have to be played with positive probability. This is because the effect
of the reputation φβ (·) on the manager’s payoff is bounded, whereas that of current return r is
not. But this implies that φ0 (·) is calculated using Bayesian updating, and as a result it cannot
be a function of r, since in this case r provides no information on the manager’s ability α.
Fix sm , then the manager’s expected payoff while investing in an index tracking strategy
β = 1 is not a function of s. On the other hand, her payoff under the idiosyncratic strategy is
a function of r. In particular, it follows from the definition of monotonic equilibria that this
is increasing in s, which proves that the manager’s equilibrium strategy is a cut-off one, as
presented in (3.11).
In addition, the indifference condition that defines h(sm ) is
h i
Er a + δ · λ · [φ0 (r, sm ) · (uH − uL ) + uL ] s = h(sm ), α = H
h i
= Er m + δ · λ · [φ0 (sm ) · (uH − uL ) + uL ] sm

while the one that defines l(sm ) is

h i
Er a + δ · λ · [φ0 (r, sm ) · (uH − uL ) + uL ] s = l(sm ), α = L
h i
= Er m + δ · λ · [φ0 (sm ) · (uH − uL ) + uL ] sm

But the right hand sides of the above two equations are the same, hence the two expressions
on the left hand sides are equal. Therefore, the expectations of the two conditional normals
B.1 Appendix: Omitted Proofs 73

that are used in the two left hand sides have to be the same, which implies that

(1 − ψ) · H + ψ · h(sm ) = (1 − ψ) · L + ψ · l(sm )

from which (3.12) follows. □

Proof: [Proof of Lemma 2] The time subscripts are suppressed, when no ambiguity is
created. The same is true for the signal sm in the cutoffs h(sm ) and l(sm ). To find the posterior
φ0 (r) calculate
     
P r, β = 0 sm , H = P r β = 0, sm , H × P β = 0 sm , H ,

where !
  h−H
P β = 0 s , H = P(s ≥ h | s , H) = Φ −
m m
, (B.1)
ν
and
∞
r − (1 − ψ)H − ψs
Z !  s − H  1/ν
1
P (r | β = 0, s , H) =
m
ϕ √ × √ ϕ  ds
ψν ψν ν

h Φ − h−H
ν

Hence, substituting gives that

! ϕ  s−H 
∞
r − (1 − ψ)H − ψsi
Z
ν
P (r, β = 0 | sm , H) = ϕ √ √ 2 ds. (B.2)
h ψν ψν

Let s̃ = (s − H)/ν, then the above becomes

∞
ϕ( s̃)
Z !
r−H p
ϕ √ − ψ s̃ √ d s̃
h−H
ν
ψ ν ψ ν
!
ϕ √ r−H
Z ∞  s̃ − r−H  p
ν ψ(1+ψ) ν(1+ψ) 
= p ϕ  p  1 + ψ d s̃

(B.3)
ν ψ(1 + ψ) ν 1/ 1 + ψ
h−H

!
ϕ √ r−H  
ν ψ(1+ψ)  r − h(1 + ψ) + Hψ 
= p Φ   .
ν ψ(1 + ψ) ν 1+ψ
p

Repeat the same process to find P (r | β = 0, sm , L) and observe that it follows from Bayes’
rule that !−1
1 − π P (r, β = 0 | sm , L)
φ0 (r) = 1 + , (B.4)
π P (r, β = 0 | sm , H)
B.1 Appendix: Omitted Proofs 74

from which the provided formula follows. To derive φ1 use Bayes’ rule to get that
!−1
1 − π P (β = 1 | sm , L)
φ1 = 1 + , (B.5)
π P (β = 1 | sm , H)

where P (β = 1 | sm , α) = 1 − P (β = 0 | sm , α), which has been derived above. □

To prove our existence theorem we need the following three lemmas.

Lemma 4 If M(·) is the normal hazard function, then for a ≥ b we have,

M(a) − M(b) ≤ a − b (B.6)

Proof: Since the hazard function is a continuous function, we can use the Mean Value
Theorem, which says that for any a > b there exists a ξ ∈ (a, b) such that M(a) − M(b) =
M ′ (ξ)(a − b). Therefore, it is sufficient to prove that M ′ (ξ) < 1 for any ξ. To prove that, note
that M(·) is convex, and hence M ′ (·) is increasing, so it would be sufficient to prove that
lim x→∞ M ′ (x) = 1. Now we use the following inequality for the normal hazard function. We
know that for x > 0,
1
x < M(x) < x + (B.7)
x
But this easily implies that M(x) has x as its asymptote as x → ∞ (that is lim x→∞ M(x) − x =
0). Finally this implies that lim x→∞ M ′ (x) = 1 and this completes the proof (note the limit
exists because M ′ (·) is increasing and bounded, as M ′ (x) = M(x)(M(x) − x) < 1 + x12 < 2). □

Lemma 5 The time subscripted is suppressed. A sufficient condition for φ0 (r, sm ) to be

increasing in the manager’s performance r is that

1−ψ
(H − L) · ≥ l(sm1 ) − h(sm1 ). (B.8)
ψ

Proof: Suppress inputs (r, sm ), and super/sub-scripts. Differentiating gives

   
dφ φ(1 − φ)  H−L  r − l(1 + ψ) + Lψ   r − h(1 + ψ) + Hψ  
=− p − + M −  − M − 
ν 1+ψ νψ 1 + ψ ν 1+ψ ν 1+ψ
p p p
dr
(B.9)

Let

δL = l(1 + ψ) − Lψ
(B.10)
δH = h(1 + ψ) − Hψ,
B.1 Appendix: Omitted Proofs 75

then the above is positive if and only if

   
H−L  δL − r   δH − r 
≥ M  p  − M  p  (B.11)
νψ 1 + ψ ν 1+ψ ν 1+ψ
p

But using Lemma 4 we see that the right hand side is bounded above by

δL − δH (l − h)(1 + ψ) + (H − L)ψ
= . (B.12)
ν 1+ψ ν 1+ψ
p p

Hence, a sufficient condition for the inequality to hold is that

H−L 1−ψ
≥ (l − h)(1 + ψ) + (H − L)ψ ⇔ (H − L) ≥ l − h. (B.13)
ψ ψ
□

Lemma 6 For c > 0, let !−1

Φ(a0 + b x)
µ(x) = 1 + c . (B.14)
Φ(a1 + b x)
Suppose b > 0, then µ′ (x) > 0 ⇔ a1 < a0 , whereas b < 0 implies that µ′ (x) > 0 ⇔ a1 > a0 .

Proof: Differentiating gives

µ′ (x) = −bµ(x)[1 − µ(x)] × [M(−a0 − b x) − M(−a1 − b x)] .

Then the statement simply follows from the fact that M(·) is increasing . □

Proof: [Proof of Proposition 1] Suppress time subscript t. Also suppress the signal sm in
the cutoffs h(sm ) and l(sm ), and in the reputations φ0 (·) and φ1 (·).
We start by proving existence. As we have argued in Lemma 1, in any monotonic
equilibrium the optimal strategy of a high and low type manager is to pick β = 0 whenever her
signal s is above the cutoffs h and l, respectively. In addition, another necessary implication
is that h and l satisfy (3.12).
But then Lemma 5 together with (3.12) give that φ0 (r) is indeed increasing in r. Hence,
the manager’s best response to the functional forms of φ0 (·) and φ1 as given in Lemma 2 is to
indeed use the cutoff strategies that Lemma 1 describes.
All that remains to prove existence is to show that those cutoffs always exist. To do this
note that the manager’s payoff maximisation problem when picking the first period’s beta is
B.1 Appendix: Omitted Proofs 76

as given in (3.10). Let her expected payoff when picking β = 0 be denoted by

h   i
v0 (s, α) = (1 − ψ) · α + ψ · s + δ · λ · Er log φ0 (r)(uH − uL ) + uL s, α ,

whereas for β = 1 this becomes

 
v1 = (1 − ψm ) · µ + ψm · sm + δ · λ · log φ1 (uH − uL ) + uL .

But then v1 is bounded, while v(s, α) goes from minus to plus infinity. Hence the manager
uses both the low and high beta strategy depending on s. Next, we provide the equation that
defines these cutoffs. Rewrite l as a function of h according to

H−L
l(h) − L = h − H + ,
ψ

and substitute this equality in φ0 (r) and φ1 to obtain the following two functions, in which
only h appears out of the two equilibrium cutoffs. Substituting in φ0 (r) gives
!
Φ r−h·(1+ψ)+Hψ−(H−L)/ψ
√ !−1
1−π ν 1+ψ
φ̃0 (r, h) = 1 + · ρ(r) · , (B.15)
π
!
Φ r−h·(1+ψ)+Hψ
√
ν 1+ψ

where h is introduced as an input of the function. Similarly, substituting in φ1 gives

 h−H+(H−L)/ψ  −1
Φ

 1−π ν

φ̃1 (h) = 1 + ·  (B.16)
π
 
Φ νh−H 

Then the cutoff h is given by the high types indifference condition v0 (h, H) = v1 , which
using the above notation becomes

r − (1 − ψ)H − ψh 1
Z h i !
δ · λ · log φ̃0 (r, h)(u − u ) + u · ϕ
H L L
√ √ dr
ψν ψν
h i
= δ · λ · log φ̃1 (h)(uH − uL ) + uL + (1 − ψm ) · µ + ψm · sm − (1 − ψ) · H − ψ · h (B.17)

where ϕ(·) is the density of the standard normal distribution. To prove existence we demon-
strate that (B.17) equation has at least one solution. Let LHS (h) denote the left hand side of
(B.17), RHS (h) its right hand side, and ∆(h) = LHS (h) − RHS (h) their difference. Observe
B.1 Appendix: Omitted Proofs 77

that all the parts of the above equation apart from the last line are bounded. As a result,

lim ∆(h) = −∞
h→−∞
(B.18)
lim ∆(h) = +∞.
h→+∞

Then it follows from the continuity of this function that there exists at least one point where
∆(h) = 0. Hence we have proven existence.
Next we show that (3.15) is indeed a sufficient condition for uniqueness. In particular,
we will argue that (3.15) implies that ∆(h) is increasing in h. First, note that LHS (h) is
increasing in h, because φ̃0 (r, h) is increasing in both r and h. We have already argued why
this is true for r. For h the claim is a direct implication of Lemma 6.
Hence it suffices to identify a condition for RHS (h) to be decreasing. Lemma 6 implies
that φ̃1 (h) is increasing in h. This is the opposite monotonicity, however we can use the fact
that the following expression has a relatively simple upper bound

φ̃1 (h)[1 − φ̃1 (h)]/ν

" ! !#
d h−H l(h) − L
log φ̃1 (h)(u − u ) + u =
H L L

× M − −M −
dh φ̃1 (h) + uHu−uL
L
ν ν
1 H
" ! !# Z !
1 h−H l(h) − L x−h H−L
≤ M − −M − = M′ dx ≤ (B.19)
ν ν ν v L−(1−ψ)H
ψ
ν ψν2

Hence, a sufficient condition for the right hand side to be decreasing, which will imply
uniqueness, is that
H−L
δλi ≤ ψ,
ψν2
which equivalently gives (3.15). □

Proof: [Proof of Proposition 2] We know that φ0 (r, sm ) is increasing in r. Hence, it

suffices to prove the conjectured result for r → −∞. The dependence on sm is suppressed.
Let k = −h(1 + ψ) + Hψ. To find the limit lim φ0 (r) we first need to calculate.
r→−∞

!
Φ r+k−(H−L)/ψ
√
ν 1+ψ
lim
r→−∞
!  2(H−L)r−(H2 −L2 )  . (B.20)
Φ √r+k exp 2ν2 ψ(1+ψ)
ν 1+ψ
B.1 Appendix: Omitted Proofs 78

Because both the numerator and the denominator go to zero as r goes to minus infinity this
limit becomes !
r+k−(H−L)/ψ
H 2 −L2 ϕ √
ν 1+ψ
e 2ν2 ψ(1+ψ) lim √
r→−∞ ν 1+ψ
 !.
ϕ √r+k
!
(H−L)r  
ν
× Φ + √
1+ψ
e ν2 ψ(1+ψ) √r+k H−L
ν2 ψ(1+ψ)

ν 1+ψ ν 1+ψ 

In addition, algebra implies the following simplification

!
ϕ r+k−(H−L)/ψ
√ 
2(r + k) − H−L 
ν 1+ψ ψ
= exp   .
 
(B.21)
2ν2 (1 + ψ)ψ/(H − L)
!
ϕ √r+k
ν 1+ψ

This in turn gives

!
ϕ r+k−(H−L)/ψ
√ 
2k − H−L 
− (H−L)r ν 1+ψ ψ
= exp   .
 
e ν2 ψ(1+ψ)
2ν2 (1 + ψ)ψ/(H − L)
!
ϕ √r+k
ν 1+ψ

Hence the limit becomes

 ! −1
 Φ ν 1+ψ
 √r+k 
 2k + H + L − H−L
  

H−L

ψ
+ 1 ,


exp  2  × lim 
 
2ν (1 + ψ)ψ/(H − L)

νψ 1 + ψ
! p
r→−∞ 
ϕ √r+k
 

ν 1+ψ

where !
Φ √r+k
ν 1+ψ 1 − Φ(x)
lim ! = lim =0 (B.22)
r→−∞ x→∞ ϕ(x)
ϕ √r+k
ν 1+ψ

Hence, substituting k we obtain that

#!−1
1−π
" !
H−L H−L
lim φ0 (r) = 1 + exp H − −h .
r→−∞ π 2ψ ψν2
B.1 Appendix: Omitted Proofs 79

Next, we want to show that the above is greater than φ1 (r) for every h. This holds if and
only if
" ! # Φ  h−H+(H−L)/ψ 
H−L H−L ν
exp H − −h < (B.23)
ψν2
 
2ψ Φ ν h−H

which can equivalently be rewritten as

 h−H+(H−L)/ψ 
H−L H−L
! Φ ν
H− −h < log . (B.24)
ψν2
 
2ψ Φ h−H
ν

Differentiating the left hand side minus the right hand side we get
! !
H−L 1 H−h 1 H−h H−L H−L H−L
− + M − M − ≤ − + = 0 (B.25)
ψν 2 ν ν ν ν νψ ψν 2 ψν2

Hence it suffices to check that

 
Φ h−H
ν
"
H−L
!
H−L
#
lim  h−H+(H−L)/ψ  ≤ exp −H .
ψν2
 (H−L)h 
h→−∞ exp ψν2
Φ ν
2ψ

Similar argumentation with the above shows that the limit on the left hand side becomes
 
ϕ h−Hν
lim  (H−L)h   h−H+(H−L)/ψ 
h→−∞ exp
ψν2
ϕ ν

 2(h − H) + H−L
 
ψ H − L (H − L)h 
= lim exp  −
2ν2 ψ ψν2 

h→−∞
" ! #
H−L H−L
= exp −H . (B.26)
2ψ ν2 ψ

Hence, the above inequality holds. □

Proof: [Proof of Proposition 3] The Input sm is suppressed. First, note that h is the
solution of (B.17), that is the solution of ∆(h) = 0, where ∆(h) is defined under the equation
as the difference of its left hand side from its right hand side. Second, the optimal cutoff
under no career concerns for the high type c(H) is the one that corresponds to the solution
of this equation for δ = 0, as this corresponds to the case when the next period is irrelevant.
Let h(δ) denote the solution of (B.17) as a function of δ. Then it follows from the implicit
B.1 Appendix: Omitted Proofs 80

function theorem that

dh(δ) ∂∆(h)/∂δ
= − . (B.27)
dδ ∂∆(h)/∂h h=h(δ)

But it follows from the limits calculated in (B.18) that the unique monotonic equilibrium
needs to have ∂∆(h)/∂h > 0. Moreover, calculating the derivative on the numerator for some
generic h gives

∂∆(h)  h i h i 
= λ Er log φ̃0 (r, h)(uH − uL ) + uL − log φ̃1 (h)(uH − uL ) + uL s = h, H ,
∂δ

but it follows from Proposition 2 that this is positive, because the difference inside the
expectation is positive for every h. As a result, for every δ ≥ 0 we get that dh(δ)/dδ < 0,
which through (3.12) implies the same for the cutoff used by the low type.
Finally, note that λ and δ enter (B.17) in exactly the same way, hence the same result can
be stated for λ. □

Lemma 7 In the unique monotonic equilibrium, for every prior reputation π > 1/2 there
exists a lower bound s̄m (π), defined as the solution of φ1 (sm ) = 1/2, such that for every
sm > s̄m we have φ1 (sm ) > 1/2, and s̄m (πi ) is increasing in π.
In addition, for every sm ≥ s̄m (π) the cutoffs h(sm ) and l(sm ) are increasing in π, and the
same is true for the posterior reputations φ(0 r, sm ) and φ1 (sm ) .

Proof: In the proof of Proposition 1 it has been shown that in the unique monotonic
equilibrium there exists φ̃1 such that φ1 (sm ) = φ̃1 [h(sm )], and its functional form is given in
(B.16). Moreover, it is an immediate implication of Lemma 6 that this is increasing in h, and
it is easy to verify that
lim φ̃1 (h) = π. (B.28)
h→+∞

In addition, it follows from (B.17), which defines h(sm ), that

uH
!
(1 + ψ)H + ψh(s ) + δλ log L ≥ (1 − ψm )µ + ψm sm .
m
u

This provides a lower bound for h(sm ), which is in an increasing function of sm , and shows
that
m
lim h(sm ) = +∞, (B.29)
s →+∞

from which the existence of the cutoffs follows. It’s monotonicity follows from using the
implicit function theorem on the equation that defines it

φ̃1 π, h s̄(π) = 1/2,



(B.30)
B.1 Appendix: Omitted Proofs 81

where note that φ̃1 is increasing in both π and h, and it has been argued in Proposition 4 that
h(·) is also an increasing function.
For the second statement, it follows from (3.12) that it suffices to prove it for h(sm ). Using
the implicit function theorem on (B.17) we get that

dh ∂∆/∂π
= − , (B.31)
dπ ∂∆/∂h

where direct differentiation gives ∂∆/∂h = ψ > 0 and that

∂∆ δλ  φ̃ (1 − φ̃ ) φ̃ (1 − φ̃ )
0 0 1 1

= Er − s = h, H , (B.32)
∂π π(1 − π) φ̃0 + uHu−uL φ̃1 + uHu−uL
L L

where the inputs r and sm have been suppressed. Some basic calculus shows that for every
φ̃ ∈ [1/2, 1] the ratio
φ̃(1 − φ̃)
(B.33)
φ̃ + uHu−uL
L

is decreasing in φ̃. Moreover, we have from Proposition 2 that φ̃0 (r, h) > φ̃1 (h) for every
r ∈ R. But we already showed that φ̃1 (h) > 1/2 for every sm ≥ s̄m (π). Hence, we get that
∂∆/∂π < 0, which implies the second statement.
Finally, the third statement follows trivially from noting that the direct derivative of both
the posteriors with respect to π is positive, and the fact that both are increasing in h(sm ),
implied by Lemma 6, for which it has already been argued that it is increasing in π. □

Proof: [Proof of Proposition 5] First, consider the investment decision of a high type
manager, for which the probability of choosing the low beta strategy, conditional on the
market signal sm , is

P β = 0 sm = P s ≥ h(sm ) sm = P h−1 (s) ≥ sm sm ,

(B.34)

since it was shown in Proposition 4 that h(·) is increasing. Moreover, for given sm the
distribution of m is normal and is given by
 
m | sm ∼ N (1 − ψm )µ + ψm sm , ψm νm2 . (B.35)

Let m̃ = [m − (1 − ψm )µ]/ψm . Then

 
m̃ | sm ∼ N sm , νm2 /ψm , (B.36)
B.1 Appendix: Omitted Proofs 82

while the ex-ante distribution of sm is

sm ∼ N µ , σ2m + νm2 ,


(B.37)

As a result using again the properties of Bayesian updating with normal distributions we get
that
ψ̃νm2
!
s | m̃ ∼ N ψ̃µ + (1 − ψ̃)m̃ ,
m
, (B.38)
ψm
where ψ̃m = (σ2m + νm2 )/(σ2m + νm2 + v2m /ψm ). Hence for every m̂, m such that m̂ > m,
the distribution of corresponding normal that generates sm conditional on m̂ first order
stochastically dominates the one of m. This immediately implies that

P β = 0 m̂ < P β = 0 m .



(B.39)

Hence under better observed market conditions the manager is less likely to have chosen to
invest in her idiosyncratic strategy. The second statement of the proposition follows from
noting that
dφ0 (r, sm ) dφ1 (sm )
≥ 0 = , (B.40)
dr dr
To calculate the left derivative it is more convenient to use the equivalent φ̃0 function from
the proof of proposition 1. The derivative of this can be calculated in a manner similar to that
used in the proof of Lemma 5 to be

dφ̃0 (r, h) φ̃0 (1 − φ̃0 )  H − L x

Z   
= p M ′ x + h 1 + ψ/ν dx ,
p
−
ν 1 + ψ νψ 1 + ψ
p
dr x

where M(·) is the hazard rate of the standard normal distribution,

r + Hψ (H − L)/ψ
x = − p and x = x+ . (B.41)
ν 1+ψ ν 1+ψ
p

Next we want to show that this derivative is decreasing in sm . This appears in φ̃0 only
indirectly through the cutoff h(sm ), which has already been shown to be an increasing
function. Hence calculate
!2
d2 φ̃0 (r, h) 1 − 2φ̃0 dφ̃0 (r, h) φ̃0 (1 − φ̃0 ) x
Z  
= M ′′ x + h 1 + ψ/ν dx ,
p
−
drdh φ̃0 (1 − φ̃0 ) dr ν2 x

the second line of which is always negative, as M(·) is a convex function. The first line
is negative as long as φ̃0 (r, h) > 1/2. But we have already argued in Proposition 2 that
B.1 Appendix: Omitted Proofs 83

φ̃0 (r, h) > φ̃1 (h), and in Lemma 7 that there exists lower bound s̄m (π) such that for all
sm ≥ s̄m (π) it has to be that φ̃1 (h) > 1/2. Moreover, the same Lemma gives that s̄m (π) is an
increasing function and it is easy to verify that for bounded m

lim P(ϕ1 (sm ) < 1/2 | m) = 0. (B.42)

π→1

dφ0 (r, sm )
Hence, indeed is decreasing in sm , from which the second statement of the
dr
proposition also follows.
□

Proof: [Proof of equation 3.18] We have:

P(φ1 > φ2 | sm ) = P(φ11 > φ21 | sm ) P(1, 1 | sm )

+ P(φ11 > φ20 | sm ) P(1, 0 | sm ) + P(φ10 > φ21 | sm ) P(0, 1 | sm )
+ P(φ10 > φ20 | sm ) P(0, 0 | sm ), (B.43)

It follows immediately from Lemma 7 that φ21 > φ11 . Moreover, Proposition 2 gives that
φ20 > φ21 , hence we also have that φ20 > φ11 . As a result the above becomes

P(φ1 > φ2 | sm ) = P(φ10 > φ21 | sm ) P(0, 1 | sm ) + P(φ10 > φ20 | sm ) P(0, 0 | sm ), (B.44)

we can only be certain about the monotonicity of the probability of both managers investing
in their idiosyncratic portfolio which is deceasing given a large sm . The rest of the terms can
not be monotonic as we have observed through simulations.
□
B.2 Appendix: Investment and AUM in the Second Period 84

B.2 Appendix: Investment and AUM in the Second Period

Here, we first derive the optimal investment decision of a manager in the second period.
Second, we use this to calculate her AUM as a function of her posterior reputation, which
we later use in order to derive her continuation payoff from period 2. To avoid repetition we
consider the extended model in which there are two fund managers. In this the investor’s
preferences are given by

t − z̄) · (1 − ft ) · Rt , i = 1, 2
 exp(zi1
 i i
v(i, zit j ) =


 exp(mt ) ,i = m

Hence, in this case there are two independent preference shocks , one for each fund. The
results of the baseline can be obtained by setting the fees of the second manager equal to one,
which will ensure that no investor will invest in her fund.
We solve the second period backwards by first considering the manager’s investment
decision when the funds have already been allocated. The manager’s expected payoff is
h i h i
E log Ai2 f2i Ri2 | si2 , sm2 , βi2 , α = log Ai2 f2i + E r2i | si2 , sm2 , βi2 , α

As a result the manager’s objective when choosing her investment strategy βi2 in the second
period is to simply maximise the expected return r2i . Thus, she invests in her alpha only if
h i h i
E r2i | si2 , sm2 , βi2 = 0, α ≥ E r2i | si2 , sm2 , βi2 = 1, α (B.45)

It is known that the posterior distributions of ai2 and m2 , after conditioning on si2 and sm2 ,
are also normal distributions with known expected values. Let ψ = σ2 /(σ2 + ν2 ) and
ψm = σ2m /(σ2m + νm2 ). Then (B.45) becomes

(1 − ψ) · α + ψ · si2 ≥ (1 − ψm ) · µ + ψm · sm2 ,

which allows us to derive the manager’s optimal investment strategy in the second period.
This is a cutoff rule such that she invests in her alpha only if si2 ≥ c(α, sm2 ), where

ψm m 1 − ψm 1−ψ
c(α, sm2 ) = · s2 + ·µ − ·α (B.46)
ψ ψ ψ
B.2 Appendix: Investment and AUM in the Second Period 85

Thus, for the same market conditions a high type manager invests relatively more fre-
quently on her alpha in the second period, as c(H, sm2 ) < c(L, sm2 ) implies

P[si2 ≥ c(H, sm2 )] > P[si2 ≥ c(L, sm2 )] ⇒ P(βi2 = 0 | m2 , α = H) > P(βi2 = 1 | m2 , α = L),

where the second line is required to infer sm2 from the realised m2 . We will frequently need
to condition expectations with respect to mt instead of smt , because we do not have some
measure of the latter in our data.
An important point that needs to be made is that the cutoffs c(α, sm2 ) are not the optimal
ones for the investors. This is because those are risk-neutral, while the managers are risk-
averse. Following the same argumentation as above we can show that the optimal cutoff for
the investors is
ψm σ2m − ψσ2
c∗ (α, sm2 ) = c(α, sm2 ) + . (B.47)
2ψ
Thus the investor’s optimal cutoff is adjusted by a “risk-loving" factor. For example, suppose
that ψm σ2m > ψσ2 , that is investing in the market is relatively more risky conditional on the
information that the manager has at her disposal when making the decision. Then an investor
would require a higher level of confidence on her alpha si2 in order to also agree that relying
on it is preferable to ’gambling’ with r2m .
Let uα2 denote the equilibrium payoff of an investor in the second period, conditional on
investing with a manager of type α, but net of his preference shock zit j and fees f2i . Then this
is given by

uα2 = P[si2 ≥ cα (sm2 )] E[Ri2 | si2 ≥ cα (sm2 )] + P[si2 ≤ cα (sm2 )] E[Ri2 | si2 ≤ cα (sm2 )], (B.48)

which has a closed form representation that can be derived using the formulas of the moment
generating function of the truncated normal distribution. We avoid providing this here as it
does not facilitate the understanding of the model in any meaningful way. However, it is
important to point out that when the market’s posterior variance ψm σ2m is much bigger than
that of the alpha-based strategy ψσ2 then the misalignment between the managers’ and the
investors’ preferences could be so substantial that a low type manager would be preferable
simply because she is more reluctant to use her alpha. We exclude that by assuming u2H > u2L ,
because if the parameters of the model were such that investing in an index tracking strategy
was so attractive, then there would be little need for professional investors.
Let φi denote the public posterior belief on manager i’s ability αi at the beginning of
period two. Then the investor’s expected payoff, net of fees and the preferences shock, from
B.2 Appendix: Investment and AUM in the Second Period 86

opting for fund i is

ui2 = φi (u2H − u2L ) + u2L ,
ij
and the corresponding actual payoff is ezt (1 − fti )ui2 . In addition, each investor has an outside
option, which is to ignore the financial intermediaries and instead invest directly on m2 ,
which gives expected payoff

um = E[exp(mt )] = eµ+σm /2 .
2

To avoid repetition note that in a manner similar to the one above we can define

ui1 = πi (u1H − u1L ) + u1L ,

as the expected net payoff of an investor active in the first period. However, in this case the
functional form of uα1 will be completely different, as the cutoffs used by the managers in the
first period will be influenced by their career concerns. We will derive those under a market
equilibrium in the next subsection.
To ensure that when the lowest preference shocks are realised the investor would rather
invest directly in the market we will assume that

(1 − f2i ) · u2H < um · ez̄ (B.49)

We are now ready to derive the AUM of fund i in the beginning of period t, as only a function
of net expected payoffs and announced fees.

Lemma 8 In any market equilibrium the AUM of fund i, competing against fund k, in period
t is
!λi  !λk 
(1 − fti )uit  λi (1 − ftk )ukt 
1 − i  . (B.50)
um λ + λk um

Proof: To simplify the algebra drop the investor superscript and time subscripts. Also let
ξi = log(1 − f i )ui , i = 1, 2 and ξm = log um + z̄. For an investor to prefer fund 1 to both
directly investing in the market and to fund 2, it has to be that

exp(z1 − z̄) · (1 − f 1 ) · u1 ≥ um ⇔ z1 ≥ ξm − ξ1

and
exp(z1 )(1 − f 1 )u1 ≥ exp(z2 )(1 − f 2 )u2 ⇔ z1 + ξ1 − ξ2 ≥ z2 ,
B.2 Appendix: Investment and AUM in the Second Period 87

respectively. Hence the proportion of the market that fund 1 captures is

 
P z1 ≥ ξm − ξ1 ∩ z1 + ξ1 − ξ2 ≥ z2
Z ∞  
= P z1 + ξ1 − ξ2 ≥ z2 z1 dP(z1 )
ξm −ξ1
Z ∞ 
1 − e−λ (z +ξ −ξ ) λ1 e−λ z dz1
2 1 1 2 1 1

=
ξm −ξ1
λ1
e−(λ +λ )(ξ −ξ )
m −ξ 1 ) 2 1 2 1 2 m 1
= e−λ1 (ξ − e−λ (ξ −ξ ) 1
λ +λ 2
λ 1
2 2 λ 
! 2

(1 − f 1 )u1 λ1
!  (1 − f )u
=

· 1 −
λ1 + λ2

um · ez̄  um · ez̄

The proof for fund 2 is equivalent. □

The proof calculates (B.50) as the probability of the intersection of two events. The first
is that investor j prefers fund i to fund k. The second is that fund i is preferred to direct
investment in the market.
To obtain the assets for the case where there is only one manager set f 2 = 1 to get:
!λi
(1 − fti ) · uit
(B.51)
um · ez̄
B.3 Appendix: Unobservable Investment Decision 88

B.3 Appendix: Unobservable Investment Decision

Lemma 9 For generic a and b:

√ a b
!
a
!
ϕ(a − bx)ϕ(x) = ϕ x 1 + b2 − √ ϕ √ . (B.52)
1 + b2 1 + b2

In addition, for generic x:

Z ∞
ab √ !
a
!
1
ϕ(a − bx)ϕ(x) dx = Φ √ − x 1 + b2 ϕ √ √ . (B.53)
x 1+b 2 1+b 2 1 + b2

Proof: The first equation follows from

a2 − 2abx + b2 x x2
!
ϕ(a − bx)ϕ(x)2π = exp − −
2 2
2 2 2 2
 (1 + b2 )x2 − 2abx + 1+b
a b a b 
 
2 a2 − 1+b 2 
= exp − −  (B.54)
2 2 
!2
 1 √
 2 

a b 1 a
= exp − 1 + b2 x − √ − .

2 1 + b2 21+b 2

The second equation follows trivially from the first. □

To make the notation more compact write r̄H (s) and r̄L (s) instead of r̄(α, β = 0, s, s ) and
m

r̄1 instead of r̄(α, β = 1, s, sm ). Similarly, write σ̄2β instead of σ̄2 (β). Also, let

β20
ξ2 ≡ σ2ϵ . (B.55)
(1 − β0 )2

Define the following function

 s 
 (r̃ − α)ψν ψ ν c − α 
2 2
ρ(r, α, c) = Φ  p
 − 1+ 2
ξ ν 

ξ ξ 2 + ψ2 ν 2

!
ϕ √2 22 r̃−α  
 c − α  ϕ r−m
ξ +ψ ν σϵ
× p +Φ , (B.56)
ξ +ψ ν
2 2 2 ν σϵ
B.3 Appendix: Unobservable Investment Decision 89

which under the restriction that β0 = 0 simplifies to

!
  ϕ √r−α  
 c − α  ϕ r−m
 r − c(1 + ψ) + αψ  ν ψ(1+ψ) σϵ
ρ(r, α, c) = Φ   × p + Φ , (B.57)
ν 1+ψ ν ψ(1 + ψ) ν σ
p
ϵ

Proof: [Proof of Lemma 3] Drop dependence on sm both in the cutoffs and on the expec-
tations. First, calculate the probability of r and β to be realised under the cutoff h. For β = β0
define the new random variable
r − β0 m β0
r̃ ≡ = a+ ϵ, (B.58)
1 − β0 1 − β0

for which we have  

r̃ | s, m ∼ N (1 − ψ)H + ψs, ξ2
β20 (B.59)
ξ2 ≡ σ2ϵ
(1 − β0 )2
as a result ∞
r̃ − (1 − ψ)H − ψs 1  s − H  1
Z !
Pr r̃, β0 | H = ϕ ϕ


ds (B.60)
h ξ ξ ν ν
Below we switch the variable of integration to s̃ = (s − H)/ν and use the above lemma

∞
r̃ − H ψν
Z !
1
Pr r̃, β0 | H = ϕ s̃ ϕ( s̃) d s̃


−
h−H
ν
ξ ξ ξ
 s   
 r̃ − H ψν/ξ ψ2 ν2 h − H   (r̃ − H)/ξ 
 p 1/ξ
= Φ  − 1+ 2  × ϕ  p ,
 
ξ 1 + ψ2 ν2 /ξ2 ξ ν  1 + ψ2 ν2 /ξ2 1 + ψ2 ν2 /ξ2
p

(B.61)

which after some algebra gives that

 s   
 (r̃ − H)ψν
 ψ ν h − H 
2 2  r̃ − H 
 p 1
Pr r̃, β0 | H = Φ  p − 1+ 2  × ϕ  p


ξ ξ2 + ψ2 ν2 ξ ν ξ 2 + ψ2 ν 2 ξ2 + ψ2 ν2
(B.62)

For β = 1, we have that r = m + ϵ, hence

! !
r−m 1 h−H
Pr r, β1 | H = ϕ Φ


(B.63)
σϵ σϵ ν
B.3 Appendix: Unobservable Investment Decision 90

Hence, we have an expression for

r − β0 m
!
Pr(r | H) = Pr r̃ = , β0 H + Pr r, β1 | H


(B.64)
1 − β0

!
ϕ √r−H  
r − β0 m  r − h(1 + ψ) + Hψ 
!
ν ψ(1+ψ)
Pr r̃ = , β0 H = Pr (r, β = 0 | H) = p Φ   . (B.65)
1 − β0 ν ψ(1 + ψ) ν 1+ψ
p

he expressions for the low type are identical, therefore it is now trivial to use Bayesian
updating to derive the posterior reputation of the manager, and complete the proof of this
Lemma. □

Proof: [Proof of Proposition 6] We want to investigate if ϕ(r, m, sm ) can be always in-

creasing in r. From Lemma 3 it is sufficient to see if ρ can always be decreasing in r, where,
ρ = ρρHL . From the previous Lemma we get:
!
!ϕ √r−L  ϕ r−µ 
ν ψ(1+ψ)

Φ r−l(1+ψ)+Lψ
√ √ +Φ l−L
ν
σε
σε
ν 1+ψ ν ψ(1+ψ)
ρ= !ϕ
! (B.66)
√r−H  ϕ r−µ 
ν ψ(1+ψ)

Φ r−h(1+ψ)+Hψ
√ √ +Φ h−H
ν
σε
σε
ν 1+ψ ν ψ(1+ψ)

Firstly, a necessary condition for ρ to be decreasing is: ν ψ(1 + ψ) = σε . After substi-

p

tuting into equation B.66, we get:

!
εA1 r−C1 Φ r−b1
√ + d1
ν 1+ψ
ρ= ! (B.67)
εA2 r−C2 Φ r−b2
√ + d2
ν 1+ψ

 
L2 −m2
where A1 = L−m
σ2ε
, C1 = 2σ2ε
, b1 = l(1 + ψ) − Lψ, d1 = Φ l−L
ν
and similarly for A2 , C2 , b2 , d2 .
B.3 Appendix: Unobservable Investment Decision 91

Note that A1 < A2 . Then we can take the derivative with respect to r, and get the following
proportionality:

   
 r − b1   r − b2 
ρ ∝e
′ A1 r−C1 A2 r−C2
e Φ  p  Φ  p  (A1 − A2 )
ν 1+ψ ν 1+ψ
        
r − b1 r − b 2 1 b1 − r b2 − r
+ eA1 r−C1 eA2 r−C2 Φ  p  Φ  p

 
 
 

 p 
 

 M  p 

 − M  p 
 

ν 1+ψ ν 1+ψ ν 1+ψ ν 1+ψ ν 1+ψ
    
    
 r − b1  1  r − b1 
+ d2 εA1 r−C1 A1 Φ  p  + εA1 r−C1 p ϕ  p


ν 1+ψ ν 1+ψ ν 1+ψ
   
r − b 2 1 r − b 2
− d1 [ϵ A2 r−C2 A2 Φ  p  + ϵ A2 r−C2 p ϕ  p

 
 
 
   ] (B.68)
ν 1+ψ ν 1+ψ ν 1+ψ

Now let P∗ denote the first 2 terms of (B.68). Then we would want to check whether the
derivative of ρ is negative for every r, m. We have:

 ! !
 Φ ν √1+ψ ϕ √
 r−b1 r−b1 
ρ′ P ∗
1 ν 1+ψ 

∝ A1 r−C1 A2 r−C2 + d2 A1 A2 r−C2 + p
 
ϵ A1 r−C1 ϵ A2 r−C2 ϵ ϵ  e ν 1+ψ e A2 r−C2  


 ! !
 Φ ν √1+ψ ϕ √
 r−b2 r−b2 
1 ν 1+ψ

− d1 A2 A1 −C1
 
ν 1+ψ A1 −C1 
p
 e e 



We take any m such that A1 , A2 < 0. Intuitively, we consider the case of a good realized
∗
market. Then ϵ A1 r−CP1 ϵ A2 r−C2 is finite (as r → ∞) because Φ(.) ∈ [0, 1] and M(a) − M(b) ≤ a − b
for a > b (Lemma 4).
We will now show that as r → ∞, the derivative cannot be negative. Indeed, we have that
as limr→∞ eAϕ(.)
2 r−C
= 0. In addition it is easily shown that, as r → +∞:
! !
d2 A1 Φ r−b1
√ d1 A2 Φ r−b2
√
ν 1+ψ d2 A1 eC2 er(A1 −A2 ) − d1 A2 eC1
ν 1+ψ
− ∼ (B.69)
eA2 r−C2 eA1 r−C1 erA1
where ∼ denotes the asymptotic equivalence of the 2 terms.
B.3 Appendix: Unobservable Investment Decision 92

We know that A1 − A2 < 0 so limr→∞ er(A1 −A2 ) = 0, hence in the limit the above expression
is asymptotically equivalent to

0 − d1 A2 eC1
(B.70)
er A1
Finally, we know that A1 < 0 so er A1 → 0 and therefore the whole expression tends to
+∞, since is also A2 < 0.
So we can finally conclude that ρ′ cannot always be negative, or in other words, a
monotonic equilibrium cannot exist.
□