Heterogeneity and Clustering of Defaults

This paper studies an economy where privately informed hedge funds (HFs) trade a risky asset in order to exploit potential mispricings. HFs are allowed to have access to credit, by using their risky assets as collateral. We analyse the role of the degree of heterogeneity among HFs’ demand for the risky asset in the emergence of clustering of defaults. We find that fire-sales caused by margin calls is a necessary, yet not a sufficient condition for defaults to be clustered. We show that when the degree of heterogeneity is sufficiently high, poorly performing HFs are able to obtain a higher than usual market share at the end of the leverage cycle, which leads to an improvement of their performance. Consequently, their survival time is prolonged, increasing the probability of them remaining in operation until the downturn of the next leverage cycle. This leads to the increase of the probability of poorly and high-performing hedge funds to default in sync at a later time, and thus the probability of collective defaults.