Hedge Funds and Limits-to-Arbitrage: Does Financial Intermediaries’ Risk Predict Hedge Fund Returns?

48 Pages Posted: 2 Jan 2019

Date Written: October 9, 2018

Abstract

This paper investigates the systematic role of limits to arbitrage in the risk and return profile of hedge funds. We follow He et al. (2017) and define these frictions in financial markets as the shocks to the equity capital ratio of primary dealer counterparties of the New York Federal Reserve. This paper demonstrates that this financial intermediaries risk is an important determinant in the cross-section of future hedge fund returns. Funds significantly loading on financial intermediaries' risk outperform low-loading funds in the next month by about 6.48% annually. The results are robust to the inclusion of other hedge fund risk factors. The paper highlights the importance of limits-to-arbitrage to understand the hedge fund industry and its risks.

Keywords: hedge funds, financial intermediaries, limits to arbitrage, asset pricing

JEL Classification: G12, G23, G24

Suggested Citation

Becam, Adrien, Hedge Funds and Limits-to-Arbitrage: Does Financial Intermediaries’ Risk Predict Hedge Fund Returns? (October 9, 2018). Available at SSRN: https://ssrn.com/abstract=3302186 or http://dx.doi.org/10.2139/ssrn.3302186

Adrien Becam (Contact Author)

Banque de France ( email )

31 rue Croix des Petits-Champs
Paris Cedex 01, 75049
France

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