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Hedge fund’s dynamic leverage decisions under time-inconsistent preferences

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  • Li, Jiangyuan
  • Liu, Bo
  • Yang, Jinqiang
  • Zou, Zhentao

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.

Suggested Citation

  • Li, Jiangyuan & Liu, Bo & Yang, Jinqiang & Zou, Zhentao, 2020. "Hedge fund’s dynamic leverage decisions under time-inconsistent preferences," European Journal of Operational Research, Elsevier, vol. 284(2), pages 779-791.
    • Handle: RePEc:eee:ejores:v:284:y:2020:i:2:p:779-791
    DOI: 10.1016/j.ejor.2019.12.037
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