Analysis of an Optimal Stopping Problem Arising from Hedge Fund Investing

Abstract

We analyze the optimal withdrawal time for an investor in a hedge fund with a first-loss or shared-loss fee structure, given as the solution of an optimal stopping problem on the fund's assets with a piecewise linear payoff function. Assuming that the underlying follows a geometric Brownian motion, we present a complete solution of the problem in the infinite horizon case, showing that the continuation region is a finite interval, and that the smooth-fit condition may fail to hold at one of the endpoints. In the finite horizon case, we show the existence of a pair of optimal exercise boundaries and analyze their properties, including smoothness and convexity.