LTCM Redux? Hedge fund Treasury trading, funding fragility, and risk constraints
Study examines the impact of Treasury market shock on hedge funds’ arbitrage, detailing risk constraints, liquidity management, and funding fragility.
What it examines
The paper studies the 2020 Treasury market shock by analyzing hedge fund arbitrage activities. It uses regulatory filings and fund-creditor data to examine how liquidity, credit, and internal risk constraints affected hedge funds, aiming to understand the limits imposed on arbitrage trading during stressful market conditions.
What it concludes
The study finds that internal risk constraints and precautionary liquidity management can worsen market instability. Its results suggest that risk management and regulatory policies should consider these factors to mitigate market stress, providing insights for future research and policy applications in treasury trading and arbitrage strategies.
Evidence objects
During the 2020 Treasury market shock, hedge funds reduced arbitrage activities and increased cash reserves, a surprising adjustment occurring despite stable credit and low redemption pressures as market behavior shifted.
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Internal risk constraints, evidenced by binding $$VaR$$ measures, drove hedge funds adjustments by restricting arbitrage and amplifying liquidity precaution strategies, ultimately significantly intensifying market instability even amid available external financing.
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Regulated dealers granted funding to significant clients, showcasing funding heterogeneity amid stress, while innovative combinations of regulatory filings and granular data deepen understanding of arbitrage dynamics and internal risk management.
key_findings bullet 3 · key_findings · validation V0
This paper examines Treasury arbitrage amid the 2020 market shock, revealing novel insights into risk and liquidity constraints using regulatory filings. Employing both established frameworks and innovative empirical analysis, it exposes $R$ funding dynamics and internal risk constraints, enriching quantitative finance literature and offering compelling, original perspectives on market instability.
key_findings bullet 4 · key_findings · validation V0
Raw abstract and provenance
We exploit the 2020 Treasury market shock to analyze how external and internal constraints impact arbitrageurs. Using regulatory filings, we find that hedge funds reduced arbitrage activities and increased cash holdings, despite stable credit and low contemporaneous redemptions. Creditors’ regulatory and liquidity constraints were not propagated to hedge funds through repo—Treasury arbitrageurs’ predominant financing source. Fund-creditor borrowing data reveal more regulated dealers provided, and more important clients received, disproportionately higher funding. Value-at-risk reported by funds suggests internal risk constraints were binding. Our results support theoretical predictions that arbitrageur risk constraints and precautionary liquidity management can amplify market instability even when contemporaneous financing remains resilient.
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