What Constrains Liquidity Provision? Evidence From Hedge Fund Trades
45 Pages Posted: 4 Oct 2013 Last revised: 11 Nov 2014
Date Written: May 30, 2013
The paper investigates the determinants of limits of arbitrage for liquidity providers. Using data on institutional transactions, we compare hedge fund trades to those of other institutions. We find that hedge funds' liquidity supply is more relevant for stock-level liquidity, but it is also more exposed to financial conditions than that of other institutions. We identify leverage, low redemptions restrictions, asset illiquidity, and reputational capital as a sufficient set of characteristics that explain the exposure of hedge funds' liquidity supply to funding conditions. Finally, we find that the trades of financially constrained hedge funds underperform for at least one quarter following negative funding shocks.
Keywords: hedge funds, limits of arbitrage, liquidity provision, trading costs, funding liquidity
JEL Classification: G20, G23
Suggested Citation: Suggested Citation