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Systemic Risk and Hedge Funds

111 Pages Posted: 7 Mar 2005  

Nicholas T. Chan

AlphaSimplex Group, LLC

Mila Getmansky

University of Massachusetts at Amherst - Eugene M. Isenberg School of Management - Department of Finance

Shane M. Haas

AlphaSimplex Group, LLC

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

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Date Written: February 22, 2005

Abstract

Systemic risk is commonly used to describe the possibility of a series of correlated defaults among financial institutions - typically banks - that occur over a short period of time, often caused by a single major event. However, since the collapse of Long Term Capital Management in 1998, it has become clear that hedge funds are also involved in systemic risk exposures. The hedge-fund industry has a symbiotic relationship with the banking sector, and many banks now operate proprietary trading units that are organized much like hedge funds. As a result, the risk exposures of the hedge-fund industry may have a material impact on the banking sector, resulting in new sources of systemic risks. In this paper, we attempt to quantify the potential impact of hedge funds on systemic risk by developing a number of new risk measures for hedge funds and applying them to individual and aggregate hedge-fund returns data. These measures include: illiquidity risk exposure, nonlinear factor models for hedge-fund and banking-sector indexes, logistic regression analysis of hedge-fund liquidation probabilities, and aggregate measures of volatility and distress based on regime-switching models. Our preliminary findings suggest that the hedge-fund industry may be heading into a challenging period of lower expected returns, and that systemic risk is currently on the rise.

Keywords: Hedge funds, systemic risk, financial crises, risk management

JEL Classification: G12

Suggested Citation

Chan, Nicholas T. and Getmansky, Mila and Haas, Shane M. and Lo, Andrew W., Systemic Risk and Hedge Funds (February 22, 2005). MIT Sloan Research Paper No. 4535-05; EFA 2005 Moscow Meetings Paper; AFA 2006 Boston Meetings Paper. Available at SSRN: https://ssrn.com/abstract=671443 or http://dx.doi.org/10.2139/ssrn.671443

Nicholas Tung Chan

AlphaSimplex Group, LLC ( email )

One Cambridge Center
Cambridge, MA 02142
United States

Mila Getmansky Sherman

University of Massachusetts at Amherst - Eugene M. Isenberg School of Management - Department of Finance ( email )

Amherst, MA 01003-4910
United States

Shane M. Haas

AlphaSimplex Group, LLC ( email )

One Cambridge Center
Cambridge, MA 02142
United States

Andrew W. Lo (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-618
Cambridge, MA 02142
United States
617-253-0920 (Phone)
781 891-9783 (Fax)

HOME PAGE: http://web.mit.edu/alo/www

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

Stata Center
Cambridge, MA 02142
United States

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