I finalized a new paper titled “The Joint Dynamics of Hedge Fund Returns, Illiquidity, and Volatility”. The paper modeld the joint dynamics of hedge fund returns and volatility as well as illiquidity in the equity and the foreign exchange (FX) market. The results show that hedge funds tend to profit from periods of low equity liquidity, but react negatively to shocks in volatility and FX illiquidity, indicating a significant FX exposure of many strategies. Moreover, I find weak evidence that hedge funds cause higher volatility in financial markets with trend following strategies being the main transmission channel. Finally, there exist cross-market dynamics and bidirectional spillovers between volatility and illiquidity in the equity and FX market. These results have important implication for performance attribution, risk management as well as regulatory policy.
The paper is available on SSRN.