The Relationship between Hedge Funds, Supply and Demand in the Stock Market - Essay Example

Hedge Funds Name Date Course Hedge Funds Introduction Stock market has recently been experiencing a lot of volatility which affects the decisions of the investors. The presence of hedge funds acts as contrarian traders which may therefore contribute to the supply of immediacy in the stock market. Equity market strategies influence the demand immediacy in the stock market. The article written by Jylha, Rinne & Suominen (2011), is about whether hedge funds supply or demand immediacy in the stock market. The article has regressed the hedge funds for the purposes of determining whether it influences the demand or supply in the stock market. The regression coefficient has been in the article to determine whether it supplies demand immediacy. A positive value of the regression coefficient is an indication that it supplies immediacy (Jylha, Rinne & Suominen, 2011). The effects of the investors withdrawing capital from the hedge has also been analyzed in the article. The capital flow as well as the time variation in the hedge has also been studied in the article to determine the effects that it has on the stock market. The aspects liquidity has also been studied in the article for the purposes of determining its relationship with the hedge funds. The paper discusses the relationship between hedge funds, supply and demand in the stock market in relation to the article. Literature Review The hedge fund portfolio allocation contributes to unexpected market wide liquidity shocks. This is especially in the case where long positions are taken in more liquid securities as compared to the short positions. Momentum strategy is required when the hedge funds are exposed to the market liquidity and hence creating immediacy (Aragon, & Strahan, 2011). The hedge funds also have significant exposure to changes in the liquidity funds and hence influencing the immediacy. The hedge funds returns in most of the stock markets are driven by the liquidity shocks. The effects of hedge funds on the stock market can also be explained by the collapse of Lehman’s Brothers which was one of the most popular banks. Excess returns in the stock market can also be useful in terms of determining whether hedge funds supply or demand immediacy in the stock market. The excess return in the stock market can be calculated through the use of a mathematical formula. Stock specific errors as well as variables are used during the calculations. The coefficients for the controls are also used in the calculations and they provide important determinants with regards to whether hedge funds supply or demand immediacy (Aragon & Strahan, 2011). Various assumptions have to be made during the calculations. This is due to some of the complexity that is involved during the calculations. However, it is also important to note that it is not clear on average whether on average hedge funds act as makers and supply immediacy. Studies have shown that there are large returns when immediacy is provided. The hedge funds employ several strategies which are useful in dealing with the stock market. One of the main strategies that are used involves ensuring that the convertible arbitrage is long in illiquid convertibles and short in liquid stocks. The hedge funds may also take long positions in illiquid small stocks for the purposes of coping with the unexpected liquidity shocks. This is considering that the liquidity shocks have the potential of increasing the liquidity premium. In order to determine whether hedge funds supply or demand immediacy, control for liquidity shocks in all the regressions can be examined (Avramov, et al, 2011). An important component that is also used is the permanent variable such as price impact. The price impact can also act as an important measure of liquidity. The residual model of changes in the levels of liquidity is can be used for the calculation of liquidity shock. On average based on the calculations, hedge funds usually supply immediacy in the stock market. This can also be supported through monitoring the bonds, currencies and commodities. On average, the hedge funds supply immediacy. However, there is a significant different in the supply of immediacy depending on the demand pattern. The discrepancies in the stock market however have the potential of altering the supply or demand immediacy (Itzhak, et al, 2011). For instance, the existence of the discrepancies in the fixed income funds trading prices. The need for immediacy by the investors is also a factor that influences the supply or demand. The alternation of the pure equity funds has the potential of influencing the demand or supply. There are various sources of cross sectional variations which influences the decision of the hedge funds to supply or demand immediacy. The main assumptions being that the hedge funds with longer lock-up periods are more likely to supply immediacy. The sources of variations can be analyzed through the use of the lock-up period of the funds, funds average size and standard deviation of the funds in relation to the capital flow. The time variation is a factor that influences the ability of the hedge fund to supply immediacy. This is further influenced by other parameters such as the number of market makers, risk aversion, number of transitory long term investors, volatility of dividends and transitory long term investors (Itzhak, et al, 2011). The speculative capital as well as the funding capital in the hedge fund influences the ability to influence immediacy. The ability of the hedge fund to supply immediacy is also influenced by other factors such as the proxy for changes in the amount of other investors, proxy for other investors need for immediacy and the volatility of other investor’s endowment shocks. Proxies for fundamental uncertainties are also a factor that influences immediacy. When the arbitrage capital increases, the hedge funds increase the supply. A large need for immediacy usually leads to an increase in the mutual fund assets. The hedge fund decreases the supply when the volatility of the capital flow into the mutual fund is high. The uncertainty regarding the fundamental values of the firm decreases the hedge funds supply immediacy. Example of liquidity and speculative capital At the time of crises, hedge funds pull out from supplying the liquidity. This is an indication that if the investors withdraw their money from the hedge funds and mutual funds a large uncertainty is created with regards to the capital flow as well as the fundamental values of the firm. This was evident during the 2008 financial crisis that had adverse effects on the stock market and financial sector. The equity of the hedge fund as well as the cost of leverage are some of the factors that affects the hedge fund industry (Boyson, et al, 2010). An increase in the capital allocated to the hedge funds has the potential of decreasing the returns available. The return reversal is also a factor that affects the hedge funds. The decision to supply immediacy has direct impacts on the amount of short term return reversal. A regression of the monthly averages plays an essential role in terms of determining the effects of the hedge funds on short-term return reversals. The liquidity shock is considered as a permanent variable price impact. The changes in cost of leverages impacts negatively on the market liquidity hence, affecting the hedge funds. An increase in the cost of leverage creates a negative return on the portfolio and hence affecting the liquidity. Hedge funds are also related to volatility on the levels of liquidity which has a direct impact on the immediacy (Brunnermeier, et al, 2009). Immediacy in the stock market is directly related to the hedge funds. This is due to the effects of the holding period and elimination of controls. Example of time variation in hedge fund supply of immediacy The supply of immediacy by the hedge funds in the stock market is quite robust. A higher propensity to supply immediacy is created by long lock-up periods, large funds and a stable investor base. A high flow of funds to the hedge flow industry increases the ability of the hedge funds to supply immediacy in the stock market. A high flow of funds to the mutual fund industry is influenced by the demand in the mutual fund sector and hence its relationship with the hedge funds. The liquidity of the market is directly related to the speculative capital. This therefore indicates that the liquidity has a direct impact on the supply of immediacy to the stock market. The decline of the stock markets usually results to the worsening of the stock liquidity. A decline in the stock market in most cases leads top to less supply of immediacy by the hedge funds. During the high lagged levels, there is a less supply of immediacy with regards to the hedge funds (Gromb, et al, 2010,). Other factors that may influence the supply of immediacy by the hedge funds includes credit spread factor, bond market factor and size spread factor. A large uncertainty regarding a firm is one of the factors that influence the supply of immediacy by the hedge funds. A stable investor base is also an important factor that has direct impacts on the supply of immediacy. The supply and demand of immediacy is useful to the investors. The decision of the investors can therefore be influenced by the supply or demand of immediacy in the stock market. Key results from the article Hedge funds to large extent provide immediacy in the stock market. Various factors usually enhance the supply of immediacy by the hedge funds to the stock market. The presence of a stable investor base is one of the factors that impacts positively on the ability of hedge funds to supply to supply immediacy in the stock market (Jylha, Rinne, & Suominen, 2011).. Time variation is a factor that influences the ability of the hedge funds to supply immediacy in the stock market. The withdrawal of capital from the hedge fund has the potential of reducing the supply immediacy of the hedge funds. The fundamental value of a firm as well as the future capital flows is has the potential of creating uncertainties. Uncertainties in the stock market are responsible for the reduction in the supply of immediacy by the hedge funds (Jylha, Rinne, & Suominen, 2011). The liquidity in the market has the potential of increasing the market liquidity which has a direct impact on the hedge funds. The information provided in the article plays an important role in creating an understanding of the topic. New ideas as well as empirical results have been provided in the article and hence contributing to its understanding. The article has also provided detailed explanations with support from statistical data. The use of statistical data ensures that the theoretical information is put into practical context. The article has also relied on recent information which is relevant to the topic. The main findings have been made as a result of the statistical analysis. Possible direction for future research Although the article has played an important role in providing the relevant information with regards to the topic, improvements need to be made. The definition of various terminologies that will be used during the research should be carried out in details. More practical examples with regards to the stock market should be explored during the research. A lot of emphasis should also be placed on the capital flow, liquidity, time as well as the other factors that have a direct impact on the hedge fund. More detailed information should also be provided with regards to the mutual fund. The risks and uncertainties should also be defined clearly and explained in details as it also has impacts on the hedge funds. The aspects of liquidity as well the stock return reversals should also be considered in future. Conclusion In conclusion, it is evident that the article provides vital information with regards to supply and demand immediacy regarding the hedge funds. The article indicates that hedge funds supply immediacy in the stock market. The information provided in the article is supported by statistics and it has also led to the creation of new ideas. It is also evident that the article has provided practical examples that are relevant to the topic. More focus is however required on the factors that affects hedge funds in the future research. List of References Aragon, G, & Strahan, E, 2011, Hedge funds as liquidity providers: evidence from Lehman bankruptcy, Journal of Financial Economics. Avramov, D, et al, 2011, Hedge funds, managerial skill, and macroeconomic variables, Journal of Financial Economics, 99(3), 672-692. Itzhak, B, et al, 2011, Hedge Funds Stock Trading during the Financial Crisis of 2007-2009, Review of Financial Studies. Boyson, N, M, et al, 2010, Hedge fund contagion and liquidity shocks, Journal of Finance 65(5), 1789-1816. Brunnermeier, M, et al, 2009, Market liquidity and funding liquidity, Review of Financial Studies 22/6, 2201-2238. Gromb, D, et al, 2010, A Model of Financial Market Liquidity Based on Intermediary Capital, Journal of the European Economic Association 8(2-3), 456-466. Jylha, P, Rinne, K, & Suominen, M, 2011, Do Hedge Funds Supply or Demand Immediacy? Research Gate Publications. Read More