Working Paper: CEPR ID: DP13645
Authors: Francesco Franzoni; Alberto Plazzi; Efe Cotelioglu
Abstract: The paper investigates the determinants of limits of arbitrage for liquidity providers. Using data on institutional transactions, we find that hedge funds' liquidity provision is more exposed to financial conditions than that of other institutions, notably mutual funds. We identify leverage, age, asset illiquidity, and reputational capital as a relevant set of characteristics that explain the exposure of hedge funds' liquidity supply to funding conditions. Stocks with more exposure to constrained liquidity providing hedge funds suffered more during the financial crisis. Finally, we find that the trades of financially constrained hedge funds underperform for at least one quarter following negative funding shocks.
Keywords: hedge funds; limits of arbitrage; liquidity provision; trading costs; funding liquidity
JEL Codes: G20; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Leverage, age, asset illiquidity, and reputational capital (G32) | Hedge funds' liquidity provision sensitivity to funding conditions (E44) |
| Hedge funds' liquidity provision sensitivity to funding conditions (E44) | Hedge funds' execution shortfall increases during financial distress (G41) |
| Funding conditions (I22) | Hedge funds' trading performance (G23) |
| Hedge funds' withdrawal from liquidity provision (G23) | Lower abnormal returns and higher trading costs for stocks (G12) |
| Higher dependence on hedge funds for liquidity (G23) | Stocks experience lower abnormal returns and higher trading costs during financial crises (G01) |
| Negative funding shocks (E44) | Deterioration of performance of constrained hedge funds (G23) |