Do Hedge Funds Reduce Idiosyncratic Risk?
University of Connecticut
London School of Economics & Political Science (LSE); Central European University (CEU)
Boston College - Carroll School of Management
December 20, 2012
Journal of Financial and Quantitative Analysis (JFQA), Forthcoming
This paper studies the effect of hedge-fund trading on idiosyncratic risk. We hypothesize that while hedge-fund activity would often reduce idiosyncratic risk, high initial levels of idiosyncratic risk might be further amplified due to fund loss limits. Panel-regression analyses provide supporting evidence for this hypothesis. The results are robust to sample selection and are further corroborated by a natural experiment using the Lehman bankruptcy as an exogenous adverse shock to hedge-fund trading. Hedge-fund capital also explains the increased idiosyncratic volatility of high-idiosyncratic-volatility stocks as well as the decreased idiosyncratic volatility of low-idiosyncratic-volatility stocks over the past few decade.
Number of Pages in PDF File: 82
Keywords: idiosyncratic risk, hedge funds
Date posted: March 11, 2011 ; Last revised: May 14, 2013