Extremal Connectedness and Systemic Risk of Hedge Funds
35 Pages Posted: 7 Feb 2020
Date Written: January 14, 2020
In this paper, we study the connectedness between extreme losses of hedge funds, a crucial feature for systemic risk management. To do so, we exploit cross-sections of hedge funds monthly returns grouped by investment styles, and build a time-varying measure of tail dependence across styles. Relying on extreme value theory and regression techniques, we study the dynamics of the tail dependencies between fund styles conditional on factors reflecting the economic uncertainty and the stock market performance. The resulting tail dependence measures are used to construct a time-varying network between extreme losses of the various investment styles. We show that during a crisis period, while the extremal dependence between some pairs of investment styles remains stable, other pairs show a striking increase of their extremal connectedness. Our results highlight that a proactive regulatory framework should account for the dynamic nature of the tail dependence and its link with financial stress.
Keywords: extreme value theory, hedge funds, systemic risk, tail dependence
JEL Classification: C56, C48, G01, G23
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