Leverage Management

An asset manager trades off the benefits of higher leverage against the costs of adjusting leverage in order to mitigate expected insolvency losses. We calculate optimal dynamic incentive-compatible leverage policies in simple versions of this problem. We give explicit conditions under which the value functions remain finite and show that following the optimal trading strategy, the fund manager does not have strong incentives to realize the loss and sell the asset when the value of the asset drops, even though such sales may help the fund to avoid insolvency.