Principal-Agent Relationship

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DEFINITION of 'Principal-Agent Relationship'

An arrangement in which one entity legally appoints another to act on its behalf. In a principal-agent relationship, the agent acts on behalf of the principal and should not have a conflict of interest in carrying out the act.

BREAKING DOWN 'Principal-Agent Relationship'

The relationship between the principal and the agent is called the "agency," and the law of agency establishes guidelines for such a relationship. The formal terms of a specific principal-agent relationship are often described in a contract.

For example, when an investor buys shares of an index fund, he is the principal, and the fund manager becomes his agent. As an agent, the index fund manager must manage the fund, which consists of many principals' assets, in a way that will maximize returns for a given level of risk in accordance with the fund's prospectus.

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