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Hedge fund contagion and liquidity

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Hedge fund contagion and liquidity

The authors Nicole M. Boyson, Christof W. Stahel, René M. Stulz, use logit and Poisson regression models to study contagion within the hedge fund industry as well as between hedge funds and the main markets.

 

I. Data
The authors describe the data used for the hedge fund returns provided by Hedge Fund Research (HFR) and the explanatory variables.

II. Tests of contagion using HFR index data
II.1. Existing approaches
The authors employ various approaches to evaluate contagion in hedge funds.
II.2. Contagion between monthly hedge fund and market indices, and between hedge fund indices
The extent to which hedge fund indices are subject to contagion is identified. The authors find no consistent evidence of contagion between hedge funds and the main markets, but significant evidence of contagion between hedge fund styles.

III. Contagion Channels
The authors investigate how funding and asset liquidity affect hedge fund contagion by using several proxies. It is found that hedge fund styles perform poorly when both funding liquidity and asset liquidity are poor at the same time, confirming the individual importance of these contagion channels.
III.2. The Poisson regression approach
Using the Poisson regression approach, the authors provide strong evidence that funding and asset liquidity are channels through which contagion takes place.

IV. Contagion between Hedge Funds and Main Markets
The authors examine whether contagion within the hedge fund industry is associated with extremely poor performance in the main markets.

V. Implications and Conclusions
Using hedge fund indices representing eight different styles, the authors find strong evidence of contagion within the hedge fund sector. The average probability that a hedge fund style index has extreme poor performance (lower 10% tail) increases from 2% to 21% as the number of other hedge fund style indices with extreme poor performance increases from zero to seven. The authors investigate how changes in funding and asset liquidity intensify this contagion, and find that the likelihood of contagion is high when prime brokerage firms have poor performance (which would be expected to affect hedge fund funding liquidity adversely) and when stock market liquidity (a proxy for asset liquidity) is low. Finally, the authors check whether extreme poor performance in the stock, bond, and currency markets is more likely when contagion in the hedge fund sector is high. No strong evidence is found validating that contagion in the hedge fund sector is associated with extreme poor performance in the stock and bond markets, however, the authors find significant evidence that performance in the currency market is worse when hedge fund contagion is high, consistent with the effects of an unwinding of carry trades.
References

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1135793

 

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