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

• DOI: 10.1016/j.frl.2021.102428
• Publication Date: 2021-09-22T04:16:02Z
• Authors: Deqing Luo; Xiaoping Wu; Jiawen Xu; Jingzhou Yan
• Keywords: Leverage (statistics)

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.