A hedge fund charges an incentive fee of 10% of any investment returns above the T-bill rate, which currently is 1.0% but is subject to a high water mark. In the first year, the fund suffers a loss of 5.5%. What rate of return must it earn in the second year to be eligible for an incentive fee

7.94%

Explanation:

From the given information; Let's assume that the initial fund value at the beginning of the year is $500.

And ; The loss for the first year will be ; $500 × 5.5 %  = $27.5

Also The T-bill (treasury bill)  will be  = $500 × 1.0 % = $5

Similarly , the opening capital for the following second year will be: = ($500 - $27.5)

= $472.5.

Thus; for the second year, the hedge fund manager must invest this $472.5 and he must  earn higher than the illustrated required rate of return below in order to be eligible for an free incentive:

Minimum required rate of return = ($27.5 + $5 + $5 )/$472.5 = 0.07936

Minimum required rate of return = 0.0794/100

Minimum required rate of return = 7.94 %

Therefore, for the hedge fund to be eligible for an incentive fee, he must earn more than 7.94%

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