Contracting for Financial Execution

Financial contracts often specify reference prices whose values are undetermined at the time of contracting, which makes them prone to manipulation. To study such situations, we introduce a stylized model of financial contracting between a client, who wishes to trade a large position, and her broker. We find that a simple contract based on the volume-weighted average price (VWAP) emerges as the unique optimal solution to this principal-agent problem. This result explains the popularity of guaranteed VWAP contracts in practice and also suggests considerations for the optimal design of financial benchmarks.