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The following two statements were posted on a web site (www.inter fluidity.com) in a discussion of agency costs and leveraged investment funds. Leveraged investment funds are funds such as a hedge funds that borrow a considerable amount of money to investment in securities.
Limited liability creates a potential conflict of interest between investment funds and their creditors. If a fund is heavily leveraged, fund investors can reap large rewards by assuming risky positions with the understanding that if those positions go sour, a large fraction of the cost can be shifted (via actual or threatened bankruptcy) to the fund’s creditors.
a. What is meant by “limited liability”?
b. Explain whether you agree or disagree with the excerpt.
Like any other sort of investment manager, the interests of those who manage funds for pensions, university endowments, and charitable foundations may diverge from the interests of their diverse clientele. In particular, rational, self-interested managers may determine that pursuing peer-competitive short-term gains is wiser than carefully managing the long-term risks of fund stakeholders.
c. What do economists call the types of costs associated with the actions described in this excerpt?
d. What is meant by “stakeholders”?