Abstract
This paper provides evidence on the interaction between hedge funds’ performance and their market liquidity risk and funding liquidity risk. Using a 2-state Markov regime switching model we identify regimes with low and high market-wide liquidity. While funds with high market liquidity risk exposures earn a premium in the high liquidity regime, this premium vanishes in the low liquidity states. Moreover, funding liquidity risk, measured by the sensitivity of a hedge fund’s return to the Treasury-Eurodollar (TED) spread, is an important determinant of fund performance. Hedge funds with high loadings on the TED spread underperform low-loading funds by about 0.49% (10.98%) annually in the high (low) liquidity regime, during 1994-2012. These results provide support for the Brunnermeier and Pedersen (2009) theoretical model that rationalizes the link between market liquidity and funding liquidity.
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