High-Water Marks Contracts Versus Recurring Option Contracts

48 Pages Posted: 23 Jun 2016

Date Written: November 2, 2015


This paper analyzes a fund manager's portfolio optimization problem when compensated by either a high-water marks (HWM) contract or a recurring option contract with a fixed benchmark rate. In a model with an indefinite number of periods, the compensations are paid out annually, while the manager's portfolio decision is made in continuous time. The manager’s utility increases with the rate of the performance fee and decreases with the level of HWM and the option contract benchmark rate. Both types of contracts encourage risk taking in general. The HWM provision has a net disciplinary effect on the manager's risk taking incentive.

Keywords: delegated portfolio management, risk-taking incentive, option contract, high-water marks, hedge funds, portfolio optimization

JEL Classification: G11; G2

Suggested Citation

Li, C. Wei, High-Water Marks Contracts Versus Recurring Option Contracts (November 2, 2015). Available at SSRN: https://ssrn.com/abstract=2799550 or http://dx.doi.org/10.2139/ssrn.2799550

C. Wei Li (Contact Author)

University of Iowa ( email )

Finance Department
Henry B. Tippie College of Business
Iowa City, IA 52242-1097
United States
319-335-0911 (Phone)
3193353690 (Fax)

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