The aim of this paper is to study the effect of financial crises on hedge fund risk. We analyze state-dependent risk exposures for various hedge fund strategies, narrow down common risk factors across different hedge fund strategies, especially, in the down-state of the market, which is of tenassociated with financial crises, and pin down contagion events that affect the whole hedge fund industry not directly driven by systematic exposure to market risk factors.
In the hedge fund literature, risk analysis is based on three main approaches. The first approach is based on the classical linear factor model applied to mutual funds. The second, introduced by Fung and Hsieh (1997), is based on a predetermined structure of the risk factors (quintile analysis or extreme event analysis). The third approach is based on option-like payoffs, also called Asset-Based Style Factors (ABS-Factors), introduced by Fung and Hsieh (2001) and Agarwal and Naik (2004). We build on the work by Fung and Hsieh (1997, 2001) and Agarwal and Naik (2004). Specifically, we extend their analysis of dynamic risk exposure in hedge funds by 1) investigating dynamic risk exposure in hedge funds conditional on the market risk factor states (based on market mean and volatility changes), and 2) introducing the evolution of the volatility of idiosyncratic risk factors for different hedge fund strategies.
Consistent with the asset pricing perspective proposed by Bekaert and Harvey (1995) and Bollen and Whaley (2007) who show that allowing for switching in risk exposure is essential when analyzing hedge fund performance, we analyze the exposure of hedge fund indexes with a factor model based on regime switching volatility, where non-linearity in the exposure is captured by factor loadings that are state-dependent. We show that the regime-switching analysis well identifies when the market risk factor is characterized by normal, down-market or up-market conditions, and the state dependent factor loadings capture the exposure of hedge funds to risk factors in these different volatility states.
This regime-switching model allows us to measure hedge fund risk exposure in different market states: up-state, normal, and down-state, which is often associated with market crises. Moreover, this model allows us to capture the change in volatility of the idiosyncratic risk factor in different hedge fund strategies. To our knowledge, this is the first paper that analyzes the evolution of volatility of the idiosyncratic risk factor for different hedge fund strategies. Capturing the evolution of volatility of the idiosyncratic risk factor for various hedge fund strategies is essential in calculating the possibility of eliminating the idiosyncratic risk through diversification. Moreover, an increase in volatility of the idiosyncratic risk factor contributes to potential margin calls for hedge fund investors.
Most importantly, the switch in volatility of the idiosyncratic risk factor allow us to investigate the eventual presence of contagion among hedge funds strategies. In our framework we define contagion among hedge funds strategies when we observe a change in the probability that all hedge funds are in the high volatility state for the idiosyncratic risk factor. Unfortunately, as in the Forbes and Rigobon (2001) framework, we cannot exclude that this event is due to the presence of a latent factor not captured by the exposure of hedge funds to systematic risk factors. Our analysis allows us to calculate the joint probability of all hedge fund strategies being in the high volatility regime of the idiosyncratic factor. This approach helps in identifying potential contagion events that may affect the whole hedge fund industry; and this result is not driven by systematic exposure to market risk factors. Our approach allows us to identify whether the switch to the high volatility regime coincides with specific financial crisis. This means that financial crises may affect the hedge fund industry not only through the dynamic exposure to market risk factors, but also through contagion among hedge fund strategies.
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Crises and Hedge Fund Risk
