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2. Question 2 (Hedge fund manager contracts). This question extends lextures 15-16 where we briefly tallied aboet hede famal minager contracts. Our goal here is to think throngh hor the costract impacts fond managers' incentive to take risker. Consider a bedge fund with insitial asets uoder manuggruent (AUM) of $1 billion; the fased will operate for a yrat. The manager is paid by a standatd 2+20 hedge fund coetract. That is, at the end of the year, be collects management fees of 2% of AUM, and if the fund's retarn is above off (the burdle rate), he collerts 2020 of that in performaner fors For inestance, suppose the fundi's recturn tarns wut to be 5 t. which annolants to 2%=$20 million manageneat fex. If the fand s return is below 0%, then the matager only collects mansegenest foer (a) (1 point) Please phot a gragh that repperents the manager's total pay as a fraction of the fund's retarm. Specifically, fund retarm should be on the borizotal axis and the manager's total pay is on the vertical axis. Plark the axis asd valuer as chrarly me previble. (b) (1 point) Let as now convider the rish-talieg incrative of the fond managef. Suppose the manafer chocoss betwern these two straterjesc - Strategy I yirlds a wure retern of 5 ff (a0 riak). - Strategy 2 yidhs a +20ks cetarm half of the time atal a -208t return the of her half of the time. Thes, it is a stratewy with zero expected returns and tunch lakber risk. Becates invertons like highes retarms and distike risk, strategy 2 is dlominated In straters 1 - that to, it is notere in terms of hoth riak and returns. Thas, if the manager dooser strategy 2, this is bad for investos. ein in future inviotmerti clases. Question: Please conupute the managr's eqpected pooff bunder both stratemizs his experted payoff.) (c) (1 point) Now suppose the manager is only compeneated with managemient fees but not perfuemanee feec. Ia cther words, the contract is sianilat to that uxed is mustual funds. Further mesume that, if the manaigy recrivs the matne anoust of expected payoff from twe strategied, he peefers the one with lower riak. Which strategy weuld be doone? (d) (1 point) What do yout leart from this evercise about buo the structure of the bevese fund malaiger ecoutract, telative to the structure of mattial fund manager contracts, induces risk-taking iscotives in fund munagers? (There is no "ahoolutely conect" answer. You will receive full credit as bong as yoe prowide a mansille maswer.) 2. Question 2 (Hedge fund manager contracts). This question extends lectures 15-16 where we beiefly talloud about hedee fund nunager contracts. Our goal here is to think through how the contract inepects fund managres" incentive to take risho. Consicles a hedge fund with initial aeses tander management (AUM) of $1 ballion: the fiend will operate for a year. The manager is peid by a standard 2+20 loedge fund contract. That is, at the ead of the yrae, be collects managentent foes of 2% of AUM, and if the fund's return is above oft (the hurdle rate), he colleets 20% of that in jecformance fors. For iastance, suppose the fund s return turas out to be SRC, which atwonsts to profits of $1 ballion 5%$50 nutlioe in dillse teries. The manager thert edlects $50 million 20% = $10 million in perfoemance frex, in addlition to the 81 ballion x 2%=$20 million managrement fres. If the fund's retura is below 0%, then the (a) (1 point) Please plot a graph that repersents the manager's total pay ats a function of the fund's return. Specifically, fund evturn sbould be on the hotizontal axis and the manager's total poy is on the vertical axis. P Mark the axis and walues as cleatly an promithe (b) ( 1 point) Let us nom consides the risk-taling incentiver of the fund manager. Suppeos the manager rhocoes betwera these two stritegies: - Strategy 1 yiclds a sare reterta of 5hi (wo riak). - Strategy 2 yields a +200 retarm half ef tbe time and a 205 f return the other half of the time. Thase, it is a strategy with aeto expected returas asd mach ligher risk. Because inwstors like higher returns and dislike risk, strategy 2 is daminuted by stratery 1 - that is, it is morec in terms of both riak and returns. Thess, if the manawer choocen strategy 2 , this it bod fot itreaton. tan in future investmesat rlawes Question: Ploase compute the munagris expected payoff Gunder both strategies. (The selfid bedge fund manager will doone whichever strutegy maximizes his expected payoff.) foes but not performance fors la otber works, the cuatrant is simillar to that uxed in mutual fundx. Further awner that, if the manuger recives the same amonant of expected payoff from twe stratepies, be prefers the one with lower risk. Which strategy would he dbone? (d) (1 point) What do yve learn from this exreise about bow the structure of the hedge fund manager contract, relative to the structure of mutital fund managet contracts, ioduces riak-taking incentives in fumd managers? (There is no "alsolutedy cortect" answer. You will teodive fall eredit as lotig ass you provide a metwible ansaxr.) 2. Question 2 (Hedge fund manager contracts). This question extends lextures 15-16 where we briefly tallied aboet hede famal minager contracts. Our goal here is to think throngh hor the costract impacts fond managers' incentive to take risker. Consider a bedge fund with insitial asets uoder manuggruent (AUM) of $1 billion; the fased will operate for a yrat. The manager is paid by a standatd 2+20 hedge fund coetract. That is, at the end of the year, be collects management fees of 2% of AUM, and if the fund's retarn is above off (the burdle rate), he collerts 2020 of that in performaner fors For inestance, suppose the fundi's recturn tarns wut to be 5 t. which annolants to 2%=$20 million manageneat fex. If the fand s return is below 0%, then the matager only collects mansegenest foer (a) (1 point) Please phot a gragh that repperents the manager's total pay as a fraction of the fund's retarm. Specifically, fund retarm should be on the borizotal axis and the manager's total pay is on the vertical axis. Plark the axis asd valuer as chrarly me previble. (b) (1 point) Let as now convider the rish-talieg incrative of the fond managef. Suppose the manafer chocoss betwern these two straterjesc - Strategy I yirlds a wure retern of 5 ff (a0 riak). - Strategy 2 yidhs a +20ks cetarm half of the time atal a -208t return the of her half of the time. Thes, it is a stratewy with zero expected returns and tunch lakber risk. Becates invertons like highes retarms and distike risk, strategy 2 is dlominated In straters 1 - that to, it is notere in terms of hoth riak and returns. Thas, if the manager dooser strategy 2, this is bad for investos. ein in future inviotmerti clases. Question: Please conupute the managr's eqpected pooff bunder both stratemizs his experted payoff.) (c) (1 point) Now suppose the manager is only compeneated with managemient fees but not perfuemanee feec. Ia cther words, the contract is sianilat to that uxed is mustual funds. Further mesume that, if the manaigy recrivs the matne anoust of expected payoff from twe strategied, he peefers the one with lower riak. Which strategy weuld be doone? (d) (1 point) What do yout leart from this evercise about buo the structure of the bevese fund malaiger ecoutract, telative to the structure of mattial fund manager contracts, induces risk-taking iscotives in fund munagers? (There is no "ahoolutely conect" answer. You will receive full credit as bong as yoe prowide a mansille maswer.) 2. Question 2 (Hedge fund manager contracts). This question extends lectures 15-16 where we beiefly talloud about hedee fund nunager contracts. Our goal here is to think through how the contract inepects fund managres" incentive to take risho. Consicles a hedge fund with initial aeses tander management (AUM) of $1 ballion: the fiend will operate for a year. The manager is peid by a standard 2+20 loedge fund contract. That is, at the ead of the yrae, be collects managentent foes of 2% of AUM, and if the fund's return is above oft (the hurdle rate), he colleets 20% of that in jecformance fors. For iastance, suppose the fund s return turas out to be SRC, which atwonsts to profits of $1 ballion 5%$50 nutlioe in dillse teries. The manager thert edlects $50 million 20% = $10 million in perfoemance frex, in addlition to the 81 ballion x 2%=$20 million managrement fres. If the fund's retura is below 0%, then the (a) (1 point) Please plot a graph that repersents the manager's total pay ats a function of the fund's return. Specifically, fund evturn sbould be on the hotizontal axis and the manager's total poy is on the vertical axis. P Mark the axis and walues as cleatly an promithe (b) ( 1 point) Let us nom consides the risk-taling incentiver of the fund manager. Suppeos the manager rhocoes betwera these two stritegies: - Strategy 1 yiclds a sare reterta of 5hi (wo riak). - Strategy 2 yields a +200 retarm half ef tbe time and a 205 f return the other half of the time. Thase, it is a strategy with aeto expected returas asd mach ligher risk. Because inwstors like higher returns and dislike risk, strategy 2 is daminuted by stratery 1 - that is, it is morec in terms of both riak and returns. Thess, if the manawer choocen strategy 2 , this it bod fot itreaton. tan in future investmesat rlawes Question: Ploase compute the munagris expected payoff Gunder both strategies. (The selfid bedge fund manager will doone whichever strutegy maximizes his expected payoff.) foes but not performance fors la otber works, the cuatrant is simillar to that uxed in mutual fundx. Further awner that, if the manuger recives the same amonant of expected payoff from twe stratepies, be prefers the one with lower risk. Which strategy would he dbone? (d) (1 point) What do yve learn from this exreise about bow the structure of the hedge fund manager contract, relative to the structure of mutital fund managet contracts, ioduces riak-taking incentives in fumd managers? (There is no "alsolutedy cortect" answer. You will teodive fall eredit as lotig ass you provide a metwible ansaxr.)
