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Strategic Interaction between Hedge Funds and Prime Brokers

Author

Listed:
  • Nataliya Gerasimova

    (Norwegian School of Economics (NHH) - Department of Finance)

  • Eric Jondeau

    (UUniversity of Lausanne - Faculty of Business and Economics (HEC Lausanne); Swiss Finance Institute)

Abstract

We develop a framework for the strategic interaction between a hedge fund and a prime broker. The hedge fund optimally determines its cash holdings and the fraction of shorted securities. The prime broker optimally determines its cash holdings, the margin rates, and the rehypothecation rate. The hedge fund and the prime broker make optimal decisions to maximize their expected return on equity. We describe how the evolution of market returns affects the equity of the hedge fund and may force it to delever or even default. Because an eventual default of the hedge fund would severely affect the prime broker’s performance, the prime broker determines the lending rate to cover its expected loss in case of a default. We then explore the strategic interaction between hedge fund and prime broker decisions by calibrating and solving our model for realistic parametrizations. We find that this interaction may give rise to some undesirable implications, such as an increase in overall risk and leverage, when the regulator controls only the prime broker’s balance sheet.

Suggested Citation

  • Nataliya Gerasimova & Eric Jondeau, 2018. "Strategic Interaction between Hedge Funds and Prime Brokers," Swiss Finance Institute Research Paper Series 18-54, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp1854
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    File URL: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3236260
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    Cited by:

    1. Nina Boyarchenko & Thomas M. Eisenbach & Pooja Gupta & Or Shachar & Peter Van Tassel, 2018. "Bank-intermediated arbitrage," Staff Reports 858, Federal Reserve Bank of New York.

    More about this item

    Keywords

    Hedge fund; Prime broker; Leverage; Balance sheet; Financing decisions;
    All these keywords.

    JEL classification:

    • G2 - Financial Economics - - Financial Institutions and Services
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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