Knowledge that Transforms

We develop a new systematic tail risk measure for equity-oriented hedge funds to examine the impact of tail risk on fund performance and to identify the sources of tail risk. We find that tail risk affects the cross-sectional variation in fund returns and that investments in both tail-sensitive stocks and options drive tail risk. Moreover, leverage and exposure to funding liquidity shocks are important determinants of tail risk. We find evidence of some funds being able to time tail risk exposure prior to the 2008–2009 financial crisis.

Most empirical studies estimate the impact of fire sales either without the benefit of market prices from frequent trades, as with aircraft sales, or without observing transaction prices, as with the forced sales of equity securities by mutual funds facing outflows. We observe both by studying firms’ sales of minority equity stakes in publicly listed third parties. We estimate the distressed sale discount to be about 8% while controlling for liquidity and for industry, or about double the 4% estimated for equity sales by distressed mutual funds. The discount becomes 13–14% if the stake sold is more than 5% of the firm or is sold as a block. Prices recover after distressed sales.

This paper explores flow patterns in corporate bond mutual funds. We show that corporate bond funds exhibit a concave flow-to-performance relationship: their outflows are sensitive to bad performance more than their inflows are sensitive to good performance. Moreover, corporate bond funds tend to have greater sensitivity of outflows to bad performance when they have more illiquid assets and when the overall market illiquidity is high. These results point to the possibility of fragility in the fast-growing corporate bond market. The illiquidity of corporate bonds may generate a first-mover advantage among investors in corporate bond funds, amplifying their response to bad performance.

We investigate the liquidity management of firms following the inception of credit default swaps (CDS) markets on their debt, which allow hedging and speculative trading on credit risk to be carried out by creditors and other parties. We find that reference firms hold more cash after CDS trading commences on their debt. The increase in cash holdings is more pronounced for CDS firms that do not pay dividends and have a higher marginal value of liquidity. For CDS firms with higher cash flow volatility, these increased cash holdings do not entail higher leverage. Overall, our findings are consistent with the view that CDS-referenced firms adopt more conservative liquidity policies to avoid negotiations with more exacting creditors.