Abstract

http://ssrn.com/abstract=2121495
 
 

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The Role of Hedge Funds in the Security Price Formation Process


Charles Cao


Pennsylvania State University

Yong Chen


Texas A&M University - Department of Finance

William N. Goetzmann


Yale School of Management - International Center for Finance; National Bureau of Economic Research (NBER)

Bing Liang


University of Massachusetts Amherst - Department of Finance & Operations Management; China Academy of Financial Research (CAFR)

March 24, 2015


Abstract:     
Using a comprehensive dataset of stock holdings by hedge funds, we empirically examine the role of hedge funds in the price formation process. Compared to other institutional investors, hedge funds tend to hold stocks that plot above the security market plane, i.e., undervalued stocks. The sample of undervalued stocks provides a unique setting in which theory makes straightforward predictions about how arbitrageurs should trade and hold mispriced assets, and how their activities should predict future stock returns. We find that in the cross-section of undervalued stocks, hedge fund ownership and trades are positively related to the degree of mispricing and arbitrage cost. A portfolio of undervalued stocks with high hedge fund ownership generates an out-of-sample risk-adjusted return of 0.48% per month, or 5.76% per year. Hedge fund ownership and trades also precede the dissipation of positive alpha. In contrast, all these patterns are nonexistent or much weaker for stocks held by non-hedge fund institutions. The findings are robust to alternative benchmark models and alternative misvaluation measures. Overall, our results suggest that hedge funds exploit and reduce stock mispricing.

Number of Pages in PDF File: 59

Keywords: Hedge funds, stock mispricing, arbitrage cost, investment value

JEL Classification: G11, G23


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Date posted: August 2, 2012 ; Last revised: April 24, 2015

Suggested Citation

Cao, Charles and Chen, Yong and Goetzmann, William N. and Liang, Bing, The Role of Hedge Funds in the Security Price Formation Process (March 24, 2015). Available at SSRN: http://ssrn.com/abstract=2121495 or http://dx.doi.org/10.2139/ssrn.2121495

Contact Information

Charles Cao
Pennsylvania State University ( email )
Department of Finance
Smeal College of Business
University Park, PA 16802
United States
814-865-7891 (Phone)
814-865-3362 (Fax)
HOME PAGE: http://www.personal.psu.edu/qxc2/cao.html
Yong Chen
Texas A&M University (TAMU) - Department of Finance ( email )
360 Wehner Building
College Station, TX 77843-4218
United States
HOME PAGE: http://people.tamu.edu/~ychen

William N. Goetzmann
Yale School of Management - International Center for Finance ( email )
135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-432-5950 (Phone)
203-432-8931 (Fax)
HOME PAGE: http://viking.som.yale.edu

National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Bing Liang (Contact Author)
University of Massachusetts Amherst - Department of Finance & Operations Management ( email )
Amherst, MA 01003
United States
China Academy of Financial Research (CAFR)
1954 Huashan Road
Shanghai P.R.China, 200030
China

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