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From Melvyn Teo, Associate Professor of Finance and Director, BNP Paribas Hedge Fund Centre at the Singapore Management University.
Abstract
Market liquidity profoundly impacts hedge funds. Funds trading illiquid securities earn a
significant risk premium, report smoother returns, can better leverage on information
asymmetries, and grapple with stronger capacity constraints. Importantly, the funding liquidity of hedge funds, or their ease of obtaining financing, can have a significant effect on the market liquidity of the securities they trade in, creating a downward liquidity spiral during economic downturns. We review the academic literature and deliver insights that resonate with recent market events.
Excerpt: Funding Liquidity and Liquidity Spirals
Thus far, the discussion has centered on how market liquidity impacts hedge funds. However, under certain circumstances, the liquidity of the hedge fund’s underlying investors and financiers can affect the market that the hedge fund trades in. For example, Mitchell, Pedersen, and Pulvino (2007) find that capital shocks to convertible arbitrage hedge funds, who are the main liquidity providers in the convertible bond markets, caused prices of convertible bonds to experience a liquidity-driven diversion from fundamentals.
Building on this, Brunnermeier and Pedersen (2009) provide a theoretical model that makes the distinction between an asset’s market liquidity (the ease with which it is traded)...................... To view our full article Click here
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