Ashwin will discuss a recent paper co-authored with Myron Scholes and soon to be submitted for publication in academic journals. Traditional academic literature has relied on so-called “limits to arbitrage” theories to explain why investment managers are unable to eliminate the effects of investor “irrational” preferences (either the asset-pricing anomalies or the behavioral finance literature) on asset pricing.
They demonstrate, however, that investment managers may not eliminate the observed asset-pricing anomalies because they may contribute to their existence. They show that if managers face constraints such as a “tracking-error constraint,” coupled with the need to hold liquidity to meet redemptions or to actively-manage investments, managers optimally hold higher-volatility securities in their portfolios.
Download the paper: http://www.gsb.stanford.edu/faculty-research/working-papers/cost-constraints-risk-management-agency-theory-asset-prices