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Heterogeneity and Clustering of Defaults

Alexandros Karlis, Giorgos Galanis, Spyridon Terovitis and Matthew Turner
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Alexandros Karlis: Department of Physics University of Warwick
Giorgos Galanis: Department of Economics University of Warwick
Spyridon Terovitis: Department of Economics University of Warwick
Matthew Turner: Centre for Complexity Science University of Warwick

The Warwick Economics Research Paper Series (TWERPS) from University of Warwick, Department of Economics

Abstract: This paper studies an economy where privately informed hedge funds (HFs) trade a risky asset in order to exploit potential mispricings. HFs are allowed to have access to credit, by using their risky assets as collateral. We analyse the role of the degree of heterogeneity among HFs' demand for the risky asset in the emergence of clustering of defaults. We find that fire-sales caused by margin calls is a necessary, yet not a sufficient condition for defaults to be clustered. We show that when the degree of heterogeneity is sufficiently high, poorly performing HFs are able to obtain a higher than usual market share at the end of the leverage cycle, which leads to an improvement of their performance. Consequently, their survival time is prolonged, increasing the probability of them remaining in operation until the downturn of the next leverage cycle. This leads to the increase of the probability of poorly and high-performing hedge funds to default in sync at a later time, and thus the probability of collective defaults.

Keywords: Hedge funds; survival statistics; systemic risk; clustering (search for similar items in EconPapers)
JEL-codes: G23 G32 G33 (search for similar items in EconPapers)
Date: 2015
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