Liquidity Risk and Limited Arbitrage: Are Banks Helping Hedge Funds Get Rich?

Abstract:     
During systematic liquidity shocks, hedge funds are able to borrow from banks and thus are not limited by capital constraints. Government-protected bank deposits receive inflows during systematic liquidity shocks. These inflows provide low cost funding and help estimate the magnitude of a shock, reducing the information asymmetry that constrains hedge funds. The unique combination of low funding cost and sophisticated information gives banks an advantage in lending to hedge funds. While banks do not participate in the upside risk that they finance, they compete away their effective government subsidy to the benefit of their hedge fund clients.

Number of Pages in PDF File: 45

Keywords: banks, hedge funds, limited arbitrage, liquidity risk

JEL Classification: G21

working papers series