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Incentive Contracts and Hedge Fund Management

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  • Jackwerth, Jens Carsten
  • Hodder, James E.

Abstract

We investigate incentive effects of a typical hedge-fund contract for a manager with power utility. With a one-year horizon, she displays risk-taking that varies dramatically with fund value. We extend the model to multiple yearly evaluation periods and find her risk-taking is rapidly moderated if the fund performs reasonably well. The most realistic approach to modeling fund closure uses an endogenous shutdown barrier where the manager optimally chooses to shut down. The manager increases risk-taking as fund value approaches that barrier, and this boundary behavior persists strongly with multiyear horizons.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 11632.

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Date of creation: 10 May 2006
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Publication status: Published in Journal of Financial and Quantitative Analysis 4.42(2007): pp. 811-826
Handle: RePEc:pra:mprapa:11632

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Keywords: Hedge Fund; Management; Incentive;

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References

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  1. Fung, William & Hsieh, David A, 1997. "Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds," Review of Financial Studies, Society for Financial Studies, vol. 10(2), pages 275-302.
  2. Merton, Robert C., 1973. "On the pricing of corporate debt: the risk structure of interest rates," Working papers 684-73., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  3. Fung, William & Hsieh, David A., 1999. "A primer on hedge funds," Journal of Empirical Finance, Elsevier, Elsevier, vol. 6(3), pages 309-331, September.
  4. Basak, Suleyman & Pavlova, Anna & Shapiro, Alex, 2005. "Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management," CEPR Discussion Papers 5006, C.E.P.R. Discussion Papers.
  5. William N. Goetzmann & Jonathan E. Ingersoll, Jr. & Stephen A. Ross, 2004. "High Water Marks," Yale School of Management Working Papers, Yale School of Management ysm22, Yale School of Management.
  6. Jennifer N. Carpenter, 2000. "Does Option Compensation Increase Managerial Risk Appetite?," Journal of Finance, American Finance Association, vol. 55(5), pages 2311-2331, October.
  7. Suleyman Basak & Alex Shapiro & Lucie Teplá, 2006. "Risk Management with Benchmarking," Management Science, INFORMS, INFORMS, vol. 52(4), pages 542-557, April.
  8. Stephen A. Ross, 2004. "Compensation, Incentives, and the Duality of Risk Aversion and Riskiness," Journal of Finance, American Finance Association, vol. 59(1), pages 207-225, 02.
  9. William N. Goetzmann & Jonathan E. Ingersoll & Stephen A. Ross, 2003. "High-Water Marks and Hedge Fund Management Contracts," Journal of Finance, American Finance Association, vol. 58(4), pages 1685-1718, 08.
  10. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-57, August.
  11. Suleyman Basak & Anna Pavlova & Alexander Shapiro, 2007. "Optimal Asset Allocation and Risk Shifting in Money Management," Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1583-1621, 2007 21.
  12. Lucian Arye Bebchuk & Jesse M. Fried, 2003. "Executive Compensation as an Agency Problem," Journal of Economic Perspectives, American Economic Association, vol. 17(3), pages 71-92, Summer.
  13. Stephen J. Brown, 2001. "Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry," Journal of Finance, American Finance Association, vol. 56(5), pages 1869-1886, October.
  14. Chevalier, Judith & Ellison, Glenn, 1997. "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 105(6), pages 1167-1200, December.
  15. 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.
  16. Bebchuk, Lucian A. & Fried, Jesse M., 2003. "Executive Compensation as an Agency Problem," Berkeley Olin Program in Law & Economics, Working Paper Series, Berkeley Olin Program in Law & Economics qt81q3136r, Berkeley Olin Program in Law & Economics.
  17. Jennifer Carpenter, 1999. "Does Option Compensation Increase Managerial Risk Appetite?," New York University, Leonard N. Stern School Finance Department Working Paper Seires, New York University, Leonard N. Stern School of Business- 99-076, New York University, Leonard N. Stern School of Business-.
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Citations

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Cited by:
  1. Gong Zhan, 2011. "Manager fee contracts and managerial incentives," Review of Derivatives Research, Springer, vol. 14(2), pages 205-239, July.
  2. Agarwal, Vikas & Ray, Sugata, 2011. "Determinants and implications of fee changes in the hedge fund industry," CFR Working Papers 11-09, University of Cologne, Centre for Financial Research (CFR).
  3. Kolokolova, Olga, 2011. "Strategic behavior within families of hedge funds," Journal of Banking & Finance, Elsevier, vol. 35(7), pages 1645-1662, July.
  4. Serge Darolles & Christian Gouriéroux, 2013. "The Effects of Management and Provision Accounts on Hedge Fund Returns - Part I : The High Water Mark Scheme," Working Papers 2013-22, Centre de Recherche en Economie et Statistique.
  5. Franke, Günter & Krahnen, Jan Pieter, 2008. "The future of securitization," CFS Working Paper Series 2008/31, Center for Financial Studies (CFS).
  6. Castaneda, Pablo, 2005. "Portfolio Choice and Benchmarking: The Case of the Unemployment Insurance Fund in Chile," MPRA Paper 3346, University Library of Munich, Germany, revised 30 Dec 2006.
  7. G. Elaut & M. Frömmel & J. Sjödin, 2014. "Crystallization – the Hidden Dimension of Hedge Funds' Fee Structure," Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium, Ghent University, Faculty of Economics and Business Administration 14/872, Ghent University, Faculty of Economics and Business Administration.
  8. Suleyman Basak & Anna Pavlova & Alexander Shapiro, 2007. "Optimal Asset Allocation and Risk Shifting in Money Management," Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1583-1621, 2007 21.
  9. Hodder, James E. & Jackwerth, Jens Carsten, 2011. "Managerial responses to incentives: Control of firm risk, derivative pricing implications, and outside wealth management," Journal of Banking & Finance, Elsevier, vol. 35(6), pages 1507-1518, June.
  10. Lan, Yingcong & Wang, Neng & Yang, Jinqiang, 2013. "The economics of hedge funds," Journal of Financial Economics, Elsevier, vol. 110(2), pages 300-323.
  11. Peyton Young & Dean P Foster, 2008. "The Hedge Fund Game," Economics Papers 2008-W01, Economics Group, Nuffield College, University of Oxford.
  12. Basak, Suleyman & Pavlova, Anna & Shapiro, Alex, 2005. "Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management," CEPR Discussion Papers 5006, C.E.P.R. Discussion Papers.
  13. Hitoshi Matsushima, 2010. "Incentives in Hedge Funds," CARF F-Series CARF-F-205, Center for Advanced Research in Finance, Faculty of Economics, The University of Tokyo.
  14. Jens Carsten Jackwerth & James Hodder, 2005. "Employee Stock Options: Much More Valuable Than You Thought," Working Papers, Warwick Business School, Finance Group wp05-09, Warwick Business School, Finance Group.

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