Final answer:
After a loss of 6.5% in the first year, a hedge fund with a high water mark and a T-bill rate of 2.5% must earn back the loss and exceed the T-bill rate in the second year before it can charge an incentive fee. The fund must first make up for the 6.5% loss and then achieve a return greater than the 2.5% T-bill rate. Therefore, the fund requires a return of more than 9% in the second year to be eligible for the 25% incentive fee.
Step-by-step explanation:
To calculate the rate of return a hedge fund needs to earn in the second year to be eligible for an incentive fee after suffering a loss in the first year, we must consider the high water mark principle. This principle dictates that the fund must first recover the loss before any incentive fees can be charged. Since the fund lost 6.5% in the first year and the T-bill rate is 2.5%, the fund must earn back the lost 6.5% plus exceed the T-bill rate by the next year before it can charge the 25% incentive fee.
Thus, the fund must first achieve a return to bring the investment value back to the original high water mark. After recovering the loss, it can then begin to calculate incentive fees on any additional returns above the T-bill rate. To simplify the calculation, we will not make intermediate rounding while performing the calculations.
Let's calculate the exact return rate needed for the second year:
- The fund needs to make up the 6.5% loss.
- The fund also needs to surpass the T-bill rate of 2.5% before it can start charging the incentive fee.
To determine the total return required, we add the loss to be recovered and the T-bill rate: 6.5% (loss) + 2.5% (T-bill rate) = 9%. This is the break-even point before any incentive can be considered. However, to actually become eligible for incentives, the fund must earn more than this 9%. If we add the incentive fee of 25% of returns above the T-bill rate to our break-even point, the required return will be more than 9%.