Market Runs of Hedge Funds During Financial Crises

53 Pages Posted: 10 Jul 2015

See all articles by Sangwook Sung

Sangwook Sung

College of Business, Korea Advanced Institute of Science and Technology (KAIST)

Hoon Cho

Korea Advanced Institute of Science and Technology (KAIST)

Date Written: July 1, 2015

Abstract

We develop a market model to illustrate synchronized market runs by informed and rational hedge funds. A hedge fund’s capital structure is fragile because uninformed fund investors are highly loss sensitive and easily withdraw capital in response to bad news. Hedge fund managers, sharing common investors and interacting with each other through market price, sensitively react to other funds’ investment decisions. In this environment, we use a global game technique to show the likelihood of panic-based market runs arising not because of systematic risk but because of the fear of runs. We also find that when the market regime changes from a normal state (in which runs are impossible) to a “bad” state (in which runs are possible), hedge funds reduce investment prior to runs. In addition, by calculating the ex ante probability of market runs, the model shows that they are more likely to occur in a market where hedge funds hold greater market exposure and uninformed traders have greater sensitivity to past price movement. Our findings help to understand the relation between stock price deterioration and resulting hedge funds’ reactions, such as the quick leverage reduction and stock market exodus observed during the global financial crisis of 2007-2009.

Keywords: Market runs, hedge funds, limits of arbitrage, financial crisis, synchronization risk

Suggested Citation

Sung, Sangwook and Cho, Hoon, Market Runs of Hedge Funds During Financial Crises (July 1, 2015). KAIST College of Business Working Paper Series No. 2015-005, Available at SSRN: https://ssrn.com/abstract=2628500 or http://dx.doi.org/10.2139/ssrn.2628500

Sangwook Sung (Contact Author)

College of Business, Korea Advanced Institute of Science and Technology (KAIST) ( email )

85 Hoegiro, Dongdaemoon-gu
Seoul 02455
Korea, Republic of (South Korea)

Hoon Cho

Korea Advanced Institute of Science and Technology (KAIST) ( email )

373-1 Kusong-dong
Yuson-gu
Taejon 305-701, 130-722
Korea, Republic of (South Korea)

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