Risk Spillover Among Hedge Funds: The Role Of Redemptions & Fund Failures
Straight from the ECB…..
Abstract (Via ECB)
This paper aims at analysing the mortality patterns of hedge funds over the period January 1994 to May 2008. In particular, we investigate the extent to which a spillover of risk among hedge funds through redemptions and failures of other funds has affected the probability of fund failure. We find that risk spillover is significantly related to the failure probability of hedge funds, with the relation being more pronounced for redemptions than for failures of other funds. Hedge funds within the same investment style are adversely affected through both channels of risk spillover. In addition, we find that funds being diversified in assets and geographically have a significantly lower failure probability and are not affected by risk spillover via redemptions.
Introduction (Via ECB)
Against the background of the financial turmoil, investigating the extent to which hedge funds may pose a risk for financial stability is of interest for policymakers. The Financial Stability Forum (2007) identified three main sources of concerns from the hedge fund industry: a systemic risk arising from their excessive leverage, the potentially disorderly impact of their failures on banks and markets, and a market dynamics issue related to their concentrated market positions. Although a spillover of risk among hedge funds was not considered as a main issue, identifying the propagation channels of tension from one fund to another may nevertheless prove to be particularly important from a financial stability perspective.
Brief Conclusion (Via ECB)
We find that, in addition to hedge fund characteristics, a spillover of risk from one fund to another, via redemptions and/or failures of other funds, is statistically and economically significantly related to hedge funds’ failure probability. Comparing the two channels of risk spillover, investor redemptions are more strongly related to funds’ failure probability than failures of other hedge funds. Our results also show that funds within the same investment style are adversely affected through both channels of risk spillover. With regard to the impact of portfolio diversification, we find that hedge funds being diversified either in terms of assets or geographically have a significantly lower failure probability than funds being invested in just one asset class or one geographical region. In addition, hedge funds seem to benefit from diversification in the sense that diversified funds are not affected by risk spillover via investor redemptions. Finally, based on our analysis, assets under management, capital flows, restriction periods, investments into derivatives and compensation-related characteristics have a large impact on hedge funds’ failure probability and should therefore be disclosed on a confidential basis to regulators in order to enable them to get a more precise view on hedge funds’ impact on systemic risk.
