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Do Hedge Funds Reduce Idiosyncratic Risk?

Published online by Cambridge University Press:  23 January 2015

Namho Kang ,
Péter Kondor  and
Ronnie Sadka
Namho Kang
Affiliation:
namho.kang@business.uconn.edu, School of Business, University of Connecticut, 2100 Hillside Rd Unit 1041, Storrs, CT 06269
Péter Kondor
Affiliation:
kondorp@ceu.hu, Department of Economics, Central European University, Nador u 9, Budapest, H-1051, Hungary
Ronnie Sadka
Affiliation:
sadka@bc.edu, Carroll School of Management, Boston College, 140 Commonwealth Ave, Chestnut Hill, MA 02467.
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Abstract

This paper studies the effect of hedge-fund trading on idiosyncratic risk. We hypothesize that while hedge-fund activity would often reduce idiosyncratic risk, high initial levels of idiosyncratic risk might be further amplified due to fund loss limits. Panel-regression analyses provide supporting evidence for this hypothesis. The results are robust to sample selection and are further corroborated by a natural experiment using the Lehman bankruptcy as an exogenous adverse shock to hedge-fund trading. Hedge-fund capital also explains the increased idiosyncratic volatility of high-idiosyncratic-volatility stocks as well as the decreased idiosyncratic volatility of low-idiosyncratic-volatility stocks over the past few decades.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 49 , Issue 4 , August 2014 , pp. 843 - 877
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2015 

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