The Joint Dynamics of Hedge Fund Returns, Illiquidity, and Volatility

Posted: 7 Dec 2010 Last revised: 6 Sep 2012

See all articles by Jan Wrampelmeyer

Jan Wrampelmeyer

Vrije Universiteit Amsterdam, School of Business and Economics; Tinbergen Institute

Date Written: May 15, 2011

Abstract

Hedge funds are frequently blamed for increasing volatility and illiquidity in financial markets. I investigate the validity of this hypothesis by modeling the joint dynamics of hedge fund returns and volatility as well as illiquidity in the equity and the foreign exchange (FX) market. The results show that hedge funds tend to profit from periods of low equity liquidity, but react negatively to shocks in volatility and FX illiquidity, indicating a significant FX exposure of many strategies. I find only weak evidence that hedge funds' speculative trading causes higher volatility in financial markets. However, the perceived detrimental effect of hedge fund activity on financial markets can be explained by exposure to (alternative) risk factors which are correlated to volatility and illiquidity. Finally, there exist cross-market dynamics and bidirectional spillovers between volatility and illiquidity in the equity and FX market. These results have important implication for performance attribution, risk management as well as regulatory policy.

Keywords: Hedge funds, Illiquidity, Volatility, Foreign Exchange Exposure

JEL Classification: F31, G10, G12

Suggested Citation

Wrampelmeyer, Jan, The Joint Dynamics of Hedge Fund Returns, Illiquidity, and Volatility (May 15, 2011). Journal of Alternative Investments, Forthcoming, Available at SSRN: https://ssrn.com/abstract=1720909

Jan Wrampelmeyer (Contact Author)

Vrije Universiteit Amsterdam, School of Business and Economics ( email )

De Boelelaan 1105
Amsterdam, 1081HV
Netherlands

Tinbergen Institute ( email )

Burg. Oudlaan 50
Rotterdam, 3062 PA
Netherlands

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