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Do Hedge Funds Reduce Idiosyncratic Risk?

  • Namho Kang
  • Peter Kondor
  • Ronnie Sadka

This paper studies the effect of hedge-fund trading on idiosyncratic risk. We hypothesize that while hedge-fund activity would often reduce idiosyncratic risk, high initial levels of idiosyncratic risk might be further amplified due to fund loss limits. Panel-regression analyses provide supporting evidence for this hypothesis. The results are robust to sample selection and are further corroborated by a natural experiment using the Lehman bankruptcy as an exogenous adverse shock to hedge-fund trading. Hedge-fund capital also explains the increased idiosyncratic volatility of high-idiosyncratic-volatility stocks as well as the decreased idiosyncratic volatility of low-idiosyncratic-volatility stocks over the past few decade.

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Paper provided by Department of Economics, Central European University in its series CEU Working Papers with number 2012_15.

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Date of creation: 04 Oct 2012
Date of revision: 04 Oct 2012
Handle: RePEc:ceu:econwp:2012_15
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