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Self-fulfilling arbitrages necessitate crash risk

Dong-Hyun Ahn, Soohun Kim and Kyoungwon Seo

Journal of Financial Markets, 2020, vol. 51, issue C

Abstract: We propose a model in which hedge funds can initiate a sequence of arbitrage opportunities and a potential market crash without any exogenous shock. When hedge fund managers share a concern about a rare event, not necessarily affecting the fundamentals, some hedge funds may opt out for fear of redemption risk, leading to coordination failure. Our model demonstrates that the coordination failure generates an arbitrage opportunity but it comes with a chance of a market crash. It explains hedge funds’ low leverage before the recent financial crisis and discusses their conflicting features of causing a financial crisis and enhancing market efficiency.

Keywords: Fragile capital structure; Fund manager incentive (search for similar items in EconPapers)
JEL-codes: G01 G23 G28 (search for similar items in EconPapers)
Date: 2020
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Persistent link: https://EconPapers.repec.org/RePEc:eee:finmar:v:51:y:2020:i:c:s1386418120300161

DOI: 10.1016/j.finmar.2020.100547

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Journal of Financial Markets is currently edited by B. Lehmann, D. Seppi and A. Subrahmanyam

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