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Robust leverage decision under locked wealth and high-water mark contract

Deqing Luo, Xiaoping Wu, Jiawen Xu and Jingzhou Yan

Finance Research Letters, 2022, vol. 46, issue PB

Abstract: This paper investigates the effects of ambiguity on the optimal fund leverage and the private risk-taking of a hedge fund manager with a high-water mark contract and locked wealth in the fund. We derive a closed-form solution that predicts an increase in ambiguity about the market risk has a U-shaped effect on the optimal fund leverage but a monotonic decreasing effect on the private risk-taking. An increase in ambiguity about the idiosyncratic risk reduces the optimal fund leverage and raises the private risk-taking. According to the simulation, ambiguity erodes the fund wealth and the private wealth of the manager. Consumption-wealth ratio and welfare of the manager are both reduced as ambiguity increases.

Keywords: High-water mark; Robust leverage; Locked wealth; Ambiguity (search for similar items in EconPapers)
JEL-codes: G11 G23 (search for similar items in EconPapers)
Date: 2022
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finlet:v:46:y:2022:i:pb:s1544612321004177

DOI: 10.1016/j.frl.2021.102428

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