Do Hedge Funds Have Enough Capital? A Value at Risk Approach

In this paper, we examine the risk characteristics and capital adequacy of hedge funds using Value-at-Risk (VaR) as the criterion for measuring risk and estimating capital requirements. We find that a vast majority of hedge funds are adequately capitalized, with the level of under-capitalization being only 3.1% for live funds and 7.5% for dead funds. Using extreme value theory, we confirm that the VaR estimated from empirical return distributions is accurate and unbiased. Dead funds exhibit a sharp increase in VaR during the two years immediately preceding their death, while no such trend is observed for live funds. This shows that VaR, estimated using fund returns, effectively captures the risk elements of hedge funds that are related to fund death. These results are supported by those obtained by using daily hedge fund returns as well as S&P 500 index returns. Our study uses an extensive data set of more than 2,000 hedge funds. Hence the large extent of adequate capitalization that we find in the hedge fund industry has strong implications for fund managers, lenders, investors, and regulators. JEL Classification: G23; G28; G29