We develop a framework of strategic interaction between prime brokers and hedge funds. The hedge fund optimally determines its cash holdings and the fraction of shorted securities. The prime broker optimally determines its cash holdings, the margin rates, and the rehypothecation rate. The lending rate is determined at the equilibrium. Optimal decisions are obtained when the hedge fund and the prime broker maximize their expected return on equity. To do so, we describe how the evolution of the market return affects the equity of the hedge fund and may force it to delever or even default. As the eventual default of the hedge fund would severely affect the prime broker's performance, the broker tries to mitigate the risk induced by the fund by fixing the margin rates (or haircuts) it imposes to the hedge fund. We then explore the interaction between the hedge fund and the prime broker decisions by calibrating and solving our model for realistic parametrizations. We find that the interaction between the hedge fund and the prime broker may give rise to some undesirable implications such as an increase in overall risk and/or leverage.

Related Documents

Back to Top