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
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: Suggested Citation