The research analyses how salary schemes affect the information acquisition and dynamic trading strategies of traders in investment banks. Conflict arises between the bank and trader because of informational differences and differing objectives.
The agent's dynamic portfolio choice is modelled under continuous-time moral hazard with hidden actions and information. Several contracts are considered: first-best (where the trader has no informational advantage over the bank), bonus payments, linear share of returns, and quadratic contract. Contracts based on the whole return history over the compensation period are compared to contracts that only use end-of-period returns, as in static models.
Related work on the agency problem between investors and fund managers models a continuous-time principal-agent problem where the agent controls both the drift and the volatility of a Markov diffusion representing an asset value or a profit stream.
Impact of compensation on information acquisition and dynamic trading strategies