Dynamic Risk Exposure in Hedge Funds

We measure dynamic risk exposure of hedge funds to various risk factors during different market volatility conditions using the regime-switching beta model. We find that in the high-volatility regime (when the market is rolling-down) most of the strategies are negatively and significantly exposed to the Large-Small and Credit Spread risk factors. This suggests that liquidity risk and credit risk are potentially common factors for different hedge fund strategies in the down-state of the market, when volatility is high and returns are very low. We further explore the possibility that all hedge fund strategies exhibit idiosyncratic risk in a high volatility regime and find that the joint probability jumps from approximately 0% to almost 100% only during the Long-Term Capital Management (LTCM) crisis. Out-of-sample forecasting tests confirm the economic importance of accounting for the presence of market volatility regimes in determining hedge funds risk exposure.