What Constrains Liquidity Provision? Evidence from Hedge Fund Trades

Abstract

The paper investigates the determinants of limits of arbitrage for liquidity providers. Using data on institutional transactions, we find that hedge funds' liquidity provision is more exposed to financial conditions than that of other institutions, notably mutual funds. We identify leverage, age, asset illiquidity, and reputational capital as a relevant set of characteristics that explain the exposure of hedge funds' liquidity supply to funding conditions. Stocks with more exposure to constrained liquidity providing hedge funds suffered more during the financial crisis. Finally, we find that the trades of financially constrained hedge funds underperform for at least one quarter following negative funding shocks.

Keywords: funding liquidity, Hedge Funds, Limits of arbitrage, Liquidity Provision, Trading Costs

JEL Classification: G20, G23