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The fragile capital structure of hedge funds and the limits to arbitrage

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  • Liu, Xuewen
  • Mello, Antonio S.
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    Abstract

    During a financial crisis, when investors are most in need of liquidity and accurate prices, hedge funds cut their arbitrage positions and hoard cash. The paper explains this phenomenon. We argue that the fragile nature of the capital structure of hedge funds, combined with low market liquidity, creates a risk of coordination in redemptions among hedge fund investors that severely limits hedge funds' arbitrage capabilities. We present a model of hedge funds' optimal asset allocation in the presence of coordination risk among investors. We show that hedge fund managers behave conservatively and even abstain from participating in the market once coordination risk is factored into their investment decisions. The model suggests a new source of limits to arbitrage.

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    File URL: http://www.sciencedirect.com/science/article/pii/S0304405X11001498
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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 102 (2011)
    Issue (Month): 3 ()
    Pages: 491-506

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    Handle: RePEc:eee:jfinec:v:102:y:2011:i:3:p:491-506

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    Web page: http://www.elsevier.com/locate/inca/505576

    Related research

    Keywords: Limits to arbitrage; Coordination risk; Fragile capital structure; Market liquidity;

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    References

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    Cited by:
    1. Lan, Yingcong & Wang, Neng & Yang, Jinqiang, 2013. "The economics of hedge funds," Journal of Financial Economics, Elsevier, vol. 110(2), pages 300-323.
    2. Dötz, Niko & Weth, Mark, 2013. "Cash holdings of German open-end equity funds: Does ownership matter?," Discussion Papers 47/2013, Deutsche Bundesbank, Research Centre.
    3. : Haitao Li & Weina Zhang & Gi H. Kim, 2011. "The CDS-Bond Basis Arbitrage and the Cross Section of Corporate Bond Returns," Working Papers wpn11-04, Warwick Business School, Finance Group.

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