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Hedge fund’s dynamic leverage decisions under time-inconsistent preferences

Jiangyuan Li, Bo Liu, Jinqiang Yang and Zhentao Zou

European Journal of Operational Research, 2020, vol. 284, issue 2, 779-791

Abstract: We extend the continuous-time hedge fund framework to model the dynamic leverage choice of a hedge fund manager with time-inconsistent preferences. While time-inconsistency discourages the manager from investing when facing high liquidation risk, the payment of incentive fees may induce a time-inconsistent manager to be more aggressive with leverage. For the special case with no management fees, we derive the closed-form solutions and find that a time-inconsistent manager always chooses higher leverage than a time-consistent manager. The impact on the dynamic leverage strategy also depends on such factors as whether managers are sophisticated or naive in their expectations regarding future time-inconsistent behavior.

Keywords: Finance; Hedge fund; Leverage; Time-inconsistent preferences; Management fees and incentive fees (search for similar items in EconPapers)
Date: 2020
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DOI: 10.1016/j.ejor.2019.12.037

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