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Incentive compatable contracts for the sale of information

Subject

Finance

Publishing details

IFA Working Paper

Publication Year

1997

Abstract

When investment banks or securities firms sell private information about the value of an asset, there is a risk that they could transmit noisy signals to their clients to reduce the information content of the order flow, and thus enhance the profitability of their proprietary trades. This paper analyzes the design of contracts for the sale of information aligning the interests of the informed agent and his customer, to give the former some incentives to transmit informative signals. Such contracts involve (i) setting up a fund, financed by the customer and trading on the private information, and (ii) compensation the informed fund manager on the basis of the profits of the fund. It is not optimal however to design the contract so that the informed agent sells perfectly informative signals, because overall the coalition of the information seller and information purchaser benefits from adding some noise to the order flow. Optimal limited revelation of the private signal to the client is made incentive compatible by compensating the informed agent with an appropriately designed portfolio of options on the fund's profits.

Publication Research Centre

Institute of Finance and Accounting

Series Number

FIN 264

Series

IFA Working Paper

Available on ECCH

No


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