Robust leverage choice of hedge funds with rare disasters

• Published in: Finance research letters 2023-06, Vol.54, p.103689, Article 103689
• Main Authors: Yan, Jingzhou, Mu, Congming, Yan, Qianhui, Luo, Deqing
• Format: Article
• Language: English
• Subjects: Ambiguity aversion; Hedge fund; High-water mark; Leverage; Rare disasters
• ISSN: 1544-6123; 1544-6131
• DOI: 10.1016/j.frl.2023.103689

We study the effects of hedge fund manager’s ambiguity aversion for jump and diffusion risks on the leverage policy under a high-water mark contract. We find that the jump risk has an inverted U-shaped effect on the leverage choice, which can be explained by the variance effect and skewness effect. Our result also indicates that diffusion ambiguity aversion has a larger negative impact on leverage than jump ambiguity aversion. Manager’s ambiguity aversion in jump risk amplifies the skewness effect when the price jump is positive. Our findings provide some insights into the risk taking strategy of hedge fund under ambiguity. •We investigate the effects of disaster risk and ambiguity aversion on the hedge fund manager’s leverage policy.•The leverage under jump-diffusion risk has an inverted U-shaped relation with the jump size.•Under jump-diffusion risk, the manager with lower (higher) ambiguity for diffusion risk takes a higher (lower) leverage, ceteris paribus.•The manager’s ambiguity aversion to diffusion has a greater negative impact on the leverage than ambiguity aversion to jumps.