Risk Choice under High-Water Marks

The Harvard Law School Forum on Corporate Governance and Financial Regulation 2014-03-20

Summary:

Editor's Note: The following post comes to us from Itamar Drechsler of the Department of Finance at New York University Stern School of Business.

High-water mark (HWM) contracts are the predominant compensation structure for managers in the hedge fund industry. In the paper, Risk Choice under High-Water Marks, forthcoming in the Review of Financial Studies, I seek to understand the optimal dynamic risk-taking strategy of a hedge fund manager who is compensated under such a contract. This is both an interesting portfolio-choice question, and one with potentially important ramifications for the willingness of hedge funds to bear risk in their role as arbitrageurs and liquidity providers, especially in times of crises. High-water mark mechanisms are also implicit in other types of compensation structures, so insights from this question extend beyond hedge funds. An example is a corporate manager who is paid performance bonuses based on record earnings or stock price and whose choice of projects influences the firm’s level of risk.

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Link:

http://blogs.law.harvard.edu/corpgov/2014/03/20/risk-choice-under-high-water-marks/

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Tags:

academic research executive compensation fund managers hedge funds incentives itamar drechsler pay for performance risk risk-taking

Authors:

R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation,

Date tagged:

03/20/2014, 11:20

Date published:

03/20/2014, 09:03