How exposed are hedge funds to prime broker risk?

Abstract

A small group of financial intermediaries manages over 90% of the hedge fund prime brokerage business, with prior research establishing shocks to these intermediaries as a systematic risk factor. We show that the average hedge fund's exposure to systematic financial intermediary risk exceeds the intermediary risk of its holdings. This heightened exposure is asymmetric, driven solely by negative aggregate shocks to financial intermediaries. In contrast, mutual funds and other risk factors show no similar effect. Examining idiosyncratic risk, we find that large adverse shocks to an individual prime broker only impact the performance of hedge funds using that broker exclusively, highlighting diversifiability of idiosyncratic shocks. Our findings underscore the unique risks of hedge funds due to their prime brokerage dependencies.

Keywords: Intermediary risk, Prime brokerage, Systematic risk, Idiosyncratic risk

JEL Classification: G12, G23, G24.