Hedge Funds and Financial Intermediaries

Abstract

Hedge funds and financial intermediaries are connected through their prime brokerage relationship. We find that systematic financial intermediary risk is important for understanding the cross-section of hedge fund returns. We show that systematic shocks propagate from prime brokers to hedge funds and not the reverse. There is little evidence that idiosyncratic financial intermediary risk matters. We evaluate if large adverse shocks to individual prime brokers propagate to their clients, finding a significant impact only in the Lehman bankruptcy case. This impact, however, was mitigated for funds with multiple prime brokers, suggesting that even extreme prime broker shocks are diversifiable

Keywords: Hedge funds, prime brokers, systematic risk, idiosyncratic risk

JEL Classification: G12, G23, G24