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Derivatives Use and Risk Taking: Evidence from the Hedge Fund Industry

49 Pages Posted: 25 Mar 2008 Last revised: 8 Feb 2010

Yong Chen

Texas A&M University - Department of Finance

Date Written: January 31, 2010

Abstract

This paper examines the use of derivatives and its relation with risk-taking in the hedge fund industry. From a large sample of hedge funds, 71% of the funds trade derivatives. After controlling for fund strategies and characteristics, derivatives users on average exhibit lower fund risks, such as market risk, downside risk, and event risk; such risk reduction is especially pronounced for directional-style funds. Further, derivatives users engage less in risk shifting and are less likely to liquidate in a poor market state. However, the flow-performance relation suggests that investors do not differentiate derivatives users when making investing decisions.

Keywords: Hedge funds, Derivatives use, Risk taking, Risk shifting, Liquidation risk, Flow-performance relation

JEL Classification: G11, G23, G34

Suggested Citation

Chen, Yong, Derivatives Use and Risk Taking: Evidence from the Hedge Fund Industry (January 31, 2010). Journal of Financial and Quantitative Analysis (JFQA), Forthcoming; EFA 2008 Athens Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1108735

Yong Chen (Contact Author)

Texas A&M University - Department of Finance ( email )

360 Wehner Building
College Station, TX 77843-4218
United States

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