Modeling hedge fund leverage via power utility with subsistence

David P. Morton, Ivilina Popova*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

Abstract

We use a power utility function with subsistence to model leverage. We prove that as the value of the subsistence level grows the allocation in the risky asset increases. The implication of this result is that if a hedge fund uses leverage, or a high water mark, it tends to have a more aggressive investment strategy. In addition, we prove that the total risk of a portfolio held by an investor with preferences described by a power utility with subsistence is a weighted sum of the covariances between the portfolio's return and higher order powers of that return, shifted by the subsistence level.

Original languageEnglish (US)
Pages (from-to)77-85
Number of pages9
JournalJournal of Derivatives and Hedge Funds
Volume19
Issue number2
DOIs
StatePublished - May 2013

Keywords

  • hedge funds
  • leverage
  • portfolio risk
  • utility functions

ASJC Scopus subject areas

  • Finance
  • Economics and Econometrics

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