The Joint Dynamics of Hedge Fund Returns, Illiquidity, and Volatility
Posted: 7 Dec 2010 Last revised: 6 Sep 2012
Date Written: May 15, 2011
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: Suggested Citation