Robust risk choice under high-water mark contract

Congming Mu (), Jingzhou Yan () and Jinqiang Yang ()
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Congming Mu: Hunan University
Jingzhou Yan: Sichuan University
Jinqiang Yang: Shanghai University of Finance and Economics

Review of Quantitative Finance and Accounting, 2023, vol. 61, issue 1, No 9, 295-322

Abstract: Abstract By assuming that a risk-neutral hedge fund manager has ambiguous beliefs about the return process of risky asset, we study his robust risk choice under the high-water mark. The results show that without management fees, ambiguity aversion induces the manager to take more risk as the fund is close to the termination but take less risk as the fund approaches the high-water mark. With management fees, ambiguity aversion increases the induced risk aversion and moderates the manager’s incentive to take risk, predicting that it is the manager with higher rates of management fees that reduces the risky asset holdings more when he becomes less confident and/or more pessimistic about the future returns. The model implies that managers’ ambiguity aversion is a possible factor explaining hedge fund activities in stock markets during the financial crisis of 2007–2009 and in US Treasury markets during COVID-19 crisis. Finally, taxation is taken into account.

Keywords: Hedge funds; Ambiguity aversion; High-water mark; Robust risk taking (search for similar items in EconPapers)
JEL-codes: G11 G23 (search for similar items in EconPapers)
Date: 2023
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Citations: View citations in EconPapers (3)

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DOI: 10.1007/s11156-023-01152-5

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