Strategic Interaction between Hedge Funds and Prime Brokers

52 Pages Posted: 21 Aug 2018 Last revised: 29 Aug 2018

See all articles by Nataliya Gerasimova

Nataliya Gerasimova

Norwegian School of Economics (NHH) - Department of Finance

Eric Jondeau

University of Lausanne - Faculty of Business and Economics (HEC Lausanne); Swiss Finance Institute; Swiss Finance Institute

Date Written: August 21, 2018

Abstract

We develop a framework for the strategic interaction between a hedge fund and a prime broker. The hedge fund optimally determines its cash holdings and the fraction of shorted securities. The prime broker optimally determines its cash holdings, the margin rates, and the rehypothecation rate. The hedge fund and the prime broker make optimal decisions to maximize their expected return on equity. We describe how the evolution of market returns affects the equity of the hedge fund and may force it to delever or even default. Because an eventual default of the hedge fund would severely affect the prime broker’s performance, the prime broker determines the lending rate to cover its expected loss in case of a default. We then explore the strategic interaction between hedge fund and prime broker decisions by calibrating and solving our model for realistic parametrizations. We find that this interaction may give rise to some undesirable implications, such as an increase in overall risk and leverage, when the regulator controls only the prime broker’s balance sheet.

Keywords: Hedge fund, Prime broker, Leverage, Balance sheet, Financing decisions

JEL Classification: G2, G23, G24

Suggested Citation

Gerasimova, Nataliya and Jondeau, Eric, Strategic Interaction between Hedge Funds and Prime Brokers (August 21, 2018). Swiss Finance Institute Research Paper No. 18-54, Available at SSRN: https://ssrn.com/abstract=3236260 or http://dx.doi.org/10.2139/ssrn.3236260

Nataliya Gerasimova (Contact Author)

Norwegian School of Economics (NHH) - Department of Finance ( email )

Helleveien 30
N-5045 Bergen
Norway

Eric Jondeau

University of Lausanne - Faculty of Business and Economics (HEC Lausanne) ( email )

Extranef 232
Lausanne, 1012
Switzerland
+41 21 692 33 49 (Phone)

HOME PAGE: http://people.unil.ch/ericjondeau/

Swiss Finance Institute ( email )

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+41 21 692 33 49 (Phone)

Swiss Finance Institute

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Switzerland

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