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The Role of Hedge Funds in the Security Price Formation Process

53 Pages Posted: 2 Aug 2012 Last revised: 1 Mar 2016

Charles Cao

Pennsylvania State University

Yong Chen

Texas A&M University - Department of Finance

William N. Goetzmann

Yale School of Management - International Center for Finance; National Bureau of Economic Research (NBER)

Bing Liang

University of Massachusetts Amherst - Department of Finance

Date Written: February 22, 2016

Abstract

Using a comprehensive dataset of equity holdings by hedge funds, we examine whether and how hedge funds exploit and help correct mispricing. We show that hedge funds tend to hold undervalued stocks. In the cross-section of undervalued stocks, both hedge fund ownership and their trades are positively related to the degree of mispricing and idiosyncratic volatility. Further, a portfolio of undervalued stocks with high hedge fund ownership generates an abnormal return of 0.48% per month. Hedge fund ownership and trades also precede dissipation of stock mispricing. By contrast, all these patterns are either nonexistent or much weaker for non-hedge funds.

Keywords: Hedge funds, stock mispricing, investment value, costly arbitrage

JEL Classification: G11, G23

Suggested Citation

Cao, Charles and Chen, Yong and Goetzmann, William N. and Liang, Bing, The Role of Hedge Funds in the Security Price Formation Process (February 22, 2016). Available at SSRN: https://ssrn.com/abstract=2121495 or http://dx.doi.org/10.2139/ssrn.2121495

Charles Cao

Pennsylvania State University ( email )

Department of Finance
Smeal College of Business
University Park, PA 16802
United States
814-865-7891 (Phone)
814-865-3362 (Fax)

HOME PAGE: http://www.personal.psu.edu/qxc2/cao.html

Yong Chen

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

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

William N. Goetzmann

Yale School of Management - International Center for Finance ( email )

165 Whitney Ave.
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-432-5950 (Phone)
203-436-9252 (Fax)

HOME PAGE: http://viking.som.yale.edu

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Bing Liang (Contact Author)

University of Massachusetts Amherst - Department of Finance ( email )

Amherst, MA 01003
United States

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