Li, J., B. Liu, J. Yang, and Z. Zou

Publication:

European Journal of Operational Research

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]FinanceHedge fundLeverageTime-inconsistent preferencesManagement fees and incentive fees

Link: https://www.sciencedirect.com/science/article/abs/pii/S037722171931077X