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Hedge Fund Contagion and Risk-adjusted Returns: A Markov-switching Dynamic Factor Approach

Author

Listed:
  • Ozgur Akay

    () (Office of Financial Research)

  • Zeynep Senyuz

    () (Federal Reserve Board)

  • Emre Yoldas

    () (Federal Reserve Board)

Abstract

We provide an empirical analysis of two important phenomena influencing the hedge fund industry -- contagion and time variation in risk-adjusted return (alpha) -- in a flexible unified framework. After accounting for standard hedge fund pricing factors, we quantify the common latent factor in hedge fund style index returns and model its time-varying behavior using a dynamic factor framework featuring Markov regime-switching. We find that three regimes -- crash, low mean, and high mean -- are necessary to provide a complete description of joint hedge fund return dynamics. We also document significant time variation in the alpha-generating ability of all hedge fund investment styles. The period following the stock market crash of 2000 is dominated by the persistent low-return state, while the long bull market of the 1990s is associated with the strongest performance of the industry generating high positive returns. We also investigate drivers of the regime shifts in the common latent pricing factor and find that both flight to safety and large funding liquidity shocks play important roles in explaining the abrupt shift of the common factor to the crash state.

Suggested Citation

  • Ozgur Akay & Zeynep Senyuz & Emre Yoldas, 2013. "Hedge Fund Contagion and Risk-adjusted Returns: A Markov-switching Dynamic Factor Approach," Working Papers 13-06, Office of Financial Research, US Department of the Treasury.
  • Handle: RePEc:ofr:wpaper:13-06
    as

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    File URL: https://financialresearch.gov/working-papers/files/OFRwp0006_AkaySenyuzYoldas_HedgeFundContagionandRiskAdjustedReturns.pdf
    File Function: First version, 2013
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    References listed on IDEAS

    as
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    6. Upper, Christian, 2011. "Simulation methods to assess the danger of contagion in interbank markets," Journal of Financial Stability, Elsevier, vol. 7(3), pages 111-125, August.
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    8. Goodhart, Charles A. E. & Sunirand, Pojanart & Tsomocos, Dimitrios P., 2004. "A model to analyse financial fragility: applications," Journal of Financial Stability, Elsevier, vol. 1(1), pages 1-30, September.
    9. Rodrigo Cifuentes & Hyun Song Shin & Gianluigi Ferrucci, 2005. "Liquidity Risk and Contagion," Journal of the European Economic Association, MIT Press, vol. 3(2-3), pages 556-566, 04/05.
    10. Hans Degryse & Grégory Nguyen, 2004. "Interbank exposures: an empirical examination of systemic risk in the Belgian banking system," Working Paper Research 43, National Bank of Belgium.
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    Citations

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    Cited by:

    1. Georgescu, Oana-Maria, 2015. "Contagion in the interbank market: Funding versus regulatory constraints," Journal of Financial Stability, Elsevier, vol. 18(C), pages 1-18.
    2. Andrea Aguiar & Rick Bookstaber & Thomas Wipf, 2014. "A Map of Funding Durability and Risk," Working Papers 14-03, Office of Financial Research, US Department of the Treasury.
    3. Matthew Elliott & Benjamin Golub & Matthew O. Jackson, 2014. "Financial Networks and Contagion," American Economic Review, American Economic Association, vol. 104(10), pages 3115-3153, October.
    4. repec:aud:audfin:v:15:y:2017:i:147:p:418 is not listed on IDEAS
    5. Hamed Amini & Andreea Minca, 2014. "Inhomogeneous Financial Networks and Contagious Links," Working Papers hal-01081559, HAL.
    6. repec:spr:annopr:v:247:y:2016:i:2:d:10.1007_s10479-015-1857-x is not listed on IDEAS

    More about this item

    Keywords

    Hedge fund; Contagion; Risk-adjusted return; Dynamic factor models; Markov-switching; Funding liquidity; Flight to safety;

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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