In this paper we investigate the influence of two factors on the risk-taking behaviour of hedge fund managers. The first is the past performance of the fund relative to the performance of each fund's peer; and the second is the option-like features of the typical hedge fund manager's compensation structure. We aim to answer questions of the following kind: do those funds that find that their incentive option is out of the money increase risk or vice versa? We then attempt to reconcile these results with the theoretical frameworks proposed. We believe these questions are of critical importance given the recent performance of the hedge fund industry. Based on performance to end of October 2008, it is clear that many funds will find themselves considerably below their high water marks and with significantly fewer assets under management. Our work may throw some light on the likely response of hedge fund managers to this crisis.
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