Strategic Interaction between Hedge Funds and Prime Brokers
52 Pages Posted: 21 Aug 2018 Last revised: 29 Aug 2018
Date Written: August 21, 2018
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: Suggested Citation