If the risk-free interest rate is rf and equals the fund's benchmark, the portfolio's net asset value is S0, and the hedge fund manager incentive fee is 20% of profit beyond that, the incentive fee is equivalent to receiving ________ call(s) with exercise price ________.

Question

Quizplus · Accepted Answer

The incentive fee is paid on the profit above the benchmark, which is S0(1+rf) since the risk-free interest rate is rf and equals the fund's benchmark. Therefore, the profit that the hedge fund manager is entitled to receive the incentive fee is S0 - S0(1+rf) = -S0rf. As the incentive fee is 20% of this profit, it is equivalent to receiving 0.2 * (-S0rf) = -0.2 * S0 * rf. The negative sign indicates that this payment serves as a short call option, as the manager is delivering the option to the investor. The strike price is S0 since it is the net asset value of the portfolio. Therefore, the answer is option D, which indicates that it is equivalent to receiving 0.2 calls with an exercise price of S0(1+rf).

If the Risk-Free Interest Rate Is Rf and Equals the Fund's