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High-Water Marks and Hedge Fund Management Contracts with Partial Information

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  • Dandan Song

    ()

  • Jinqiang Yang

    ()

  • Zhaojun Yang

    ()

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    Abstract

    This paper extends the Goetzmann et al. (J Financ 58:1685–1717, 2003 ) model to the case of partial information, where the expected return of a hedge fund is not observable but known to be either high or low. The fund manager can dynamically update his belief about the true value of the expected return based on the realization of the net asset value of the hedge fund. Our main purpose is to study the impact of the uncertainty of the expected return on the pricing of the fund manager’s various fees and the investor’s claim. The results show that partial information has significant impact on the values of the fees and the claim. Specifically, a non-updating fund manager always underestimate the values, and more often than not, the amount underestimated is very significant. The closer the net asset value gets to the high-water mark or the larger the uncertainty of the expected return is, the bigger the amount underestimated will become. Copyright Springer Science+Business Media New York 2013

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    File URL: http://hdl.handle.net/10.1007/s10614-012-9338-7
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    Bibliographic Info

    Article provided by Society for Computational Economics in its journal Computational Economics.

    Volume (Year): 42 (2013)
    Issue (Month): 3 (October)
    Pages: 327-350

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    Handle: RePEc:kap:compec:v:42:y:2013:i:3:p:327-350

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    Web page: http://www.springerlink.com/link.asp?id=100248
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    Related research

    Keywords: High-water mark; Hedge fund; Performance fee; Partial information;

    References

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    1. Edwin J. Elton & Martin J. Gruber & Christopher R. Blake, 2003. "Incentive Fees and Mutual Funds," Journal of Finance, American Finance Association, vol. 58(2), pages 779-804, 04.
    2. Vikas Agarwal, 2004. "Risks and Portfolio Decisions Involving Hedge Funds," Review of Financial Studies, Society for Financial Studies, vol. 17(1), pages 63-98.
    3. Getmansky, Mila & Lo, Andrew W. & Makarov, Igor, 2004. "An econometric model of serial correlation and illiquidity in hedge fund returns," Journal of Financial Economics, Elsevier, vol. 74(3), pages 529-609, December.
    4. Jinqiang Yang & Zhaojun Yang, 2012. "Consumption Utility-Based Pricing and Timing of the Option to Invest with Partial Information," Computational Economics, Society for Computational Economics, vol. 39(2), pages 195-217, February.
    5. Carl Ackermann & Richard McEnally & David Ravenscraft, 1999. "The Performance of Hedge Funds: Risk, Return, and Incentives," Journal of Finance, American Finance Association, vol. 54(3), pages 833-874, 06.
    6. William N. Goetzmann & Jonathan E. Ingersoll Jr. & Stephen A. Ross, 2001. "High-Water Marks and Hedge Fund Management Contracts," Yale School of Management Working Papers ysm186, Yale School of Management.
    7. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711, December.
    8. Stavros Panageas & Mark M. Westerfield, 2009. "High-Water Marks: High Risk Appetites? Convex Compensation, Long Horizons, and Portfolio Choice," Journal of Finance, American Finance Association, vol. 64(1), pages 1-36, 02.
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