Hedge fund leverage with stochastic market conditions

Hedge funds face stochastic market conditions. We develop a dynamic framework to analyze hedge fund optimal leverage choice, in which the extra return and volatility of the alpha-generating strategy shift between good and bad states at random times. We find that the optimal leverage, the manager's risk attitude and her compensation in each state reflect the possibility for state shifts, in contrast to the results of the one-state model. The manager always intends to increase leverage when the probability of a coming crisis is higher; however, the leverage is significantly reduced when the crisis arrives.