Explanation:
The hedge fund earns a 2% management fee on assets regardless of performance, plus a 20% performance fee on profits. This makes the fund prefer higher volatility / more convex payoffs, because it participates in upside but does not share downside losses with investors.
Strategy A: profit is certain at $4.0m.
$2.0m$4.0m = $0.8m$2.8mStrategy B: expected gross profit = 0.5 × 7 + 0.5 × 0 = $3.5m.
$2.0m + 20% × (0.5 × $7.0m) = $2.0m + $0.7m = $2.7mStrategy C: expected gross profit = 0.5 × 18 + 0.5 × (−15) = $1.5m.
$2.0m + 20% × $18.0m = $5.6m$2.0m only$3.8mSo Strategy C gives the highest expected return to the hedge fund because it produces the largest expected fee income, while it is the worst for investors because the expected net return after fees is lowest (indeed negative).
Ultimate access to all questions.
Q-21.7.1. A hedge fund has USD $100.0 million of investor's funds, and it charges the traditional "2 and 20" fee schedule, i.e., 2.0% management fee plus a 20% performance fee. Consider the following three strategies:
$4.0 million and therefore return of 4.0%$7.0 million (gross) profit and a 50% chance of zero profit; the expected return is +3.5%.$18.0 million (gross) profit and a 50% chance of a -$15.0 million loss; the expected return is +1.5%.Which of the following is TRUE?
A
Strategy A offers the best expected return to the hedge fund, but the worst to the investors
B
Strategy B offers the best expected return to both the hedge fund and to the investors
C
Strategy C offers the best expected return to the hedge fund, but the worst to the investors
D
All three strategies happen to offer the same expected return to hedge fund, and the same expected return to the investors
No comments yet.