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Journal of Undergraduate Research

Keywords

moral hazard, hedge funds, stochastic differential games

College

Physical and Mathematical Sciences

Department

Mathematics

Abstract

This project is a continuation of a line of research that I have been working on over the last two years, with the object of analyzing the relationship incentive structure present in the hedge fund industry and identifying any potential for moral hazard. In economics theory, “moral hazard” is a situation in which one party is more willing to take on a risk due to the fact that he or she knows that the potential costs or burden of that risk will be borne, in part or in whole, by others. In this project, my goal was to develop a mathematical model to explore the effects of management fees and performance bonuses as well as changing market share on the fund manager’s implicit aversion towards high-risk portfolios. Because hedge fund’s trading data is typically unavailable for analysis, an empirical approach is out of the question. Rather, we can make this argument deductively, by showing that overly-risky behavior is actually optimal from the fund manager’s perspective. In essence, can we show mathematically that, given the commission-based compensation structure of the fund and the dynamics of market share, the fund manager has an incentive to take on excessively risky investments? In this report, I will detail my approach to this problem, including details of my previous attempt, and will report my experiences in working with my advisor, Professor Jeff Humpherys, and the outcomes of opportunity afforded by the ORCA grant program.

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