The Fragile Capital Structure of Hedge Funds and the Limits to Arbitrage
38 Pages Posted: 30 Apr 2009 Last revised: 2 Apr 2014
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: Suggested Citation
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