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Risk Choice Under High-Water Marks

Authors: Drechsler, Itamar
Issue Date: 18-Nov-2011
Series/Report no.: FIN-11-009
Abstract: I provide a closed-form solution to the optimal dynamic risk choice of a fund man- ager who is compensated under a high-water mark contract. The manager's optimal risk choice varies with the distance between the fund's asset value and its high-water mark. Negative returns increase the manager's eective risk aversion (`de-leveraging') when the value of his outside option is low, termination is `strict', or management fees are high, and decrease his eective risk aversion (`gambling') otherwise. I show that in the absence of limits on risk taking, it is never optimal for a manager to walk away. When there are risk limits, walk-away can be optimal following losses.
Appears in Collections:Finance Working Papers

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