The Fragile Capital Structure of Hedge Funds and the Limits to Arbitrage

38 Pages Posted: 30 Apr 2009 Last revised: 2 Apr 2014

See all articles by Xuewen Liu

Xuewen Liu

University of Hong Kong (HKU) - Finance Area, Faculty of Business and Economics

Antonio S. Mello

University of Wisconsin - Madison - Department of Finance, Investment and Banking

Date Written: February 20, 2009

Abstract

During a financial crisis, when markets most need liquidity and arbitrage tradings, hedge funds often reduce their exposures and positions. The paper explains this phenomenon in light of coordination risk. We argue that the fragile nature of capital structure of hedge funds, combined with low market liquidity, introduces coordination risk to hedge fund's investors. Coordination risk effectively limits hedge funds' arbitrage capabilities. We present a model of hedge funds' optimal asset allocation with coordination risk. We show that hedge fund managers behave conservatively and even give up participating in the market when they factor coordination risk into their investment decisions. The model gives a new explanation to the limits to arbitrage. We also discuss other implications of the model.

Keywords: Limits to arbitrage; Coordination risk; Fragile capital structure; Market liquidity

JEL Classification: G14; G24; D82

Suggested Citation

Liu, Xuewen and Mello, Antonio S., The Fragile Capital Structure of Hedge Funds and the Limits to Arbitrage (February 20, 2009). Journal of Financial Economics (JFE), Vol. 102, No. 3, 2011, Available at SSRN: https://ssrn.com/abstract=1397303 or http://dx.doi.org/10.2139/ssrn.1397303

Xuewen Liu (Contact Author)

University of Hong Kong (HKU) - Finance Area, Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

HOME PAGE: http://web.hku.hk/~xuewenl/

Antonio S. Mello

University of Wisconsin - Madison - Department of Finance, Investment and Banking ( email )

975 University Avenue
Madison, WI 53706
United States
608-263-3423 (Phone)
608-265-4195 (Fax)

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