Incentives for Traders: Ideal and Heuristic Contracts

Abstract

As noted by Stoughton (1993) and Admati and Pfleiderer (1997), different linear contracts do not give incentives for effort. An obvious solution is to use a nonlinear contract, later according to contract theory, the ideal contract also includes signal reporting or an equivalent mechanism. The ideal optimal contract is not suitable for traders, since the profit opportunity cannot be separated from the trading process. We find that giving a penalty for passivity creates an incentive for effort, without which the active position would be too risky. The penalty for passivity comes close to the ideal benchmark with additional marginal improvements from nonlinear compensation.