Hedge Fund Financial Leverage and the 2008 Systematic Crisis: When the Diversification among Strategies Does not Work

Financial Leverage seems to have a large responsibility in contributing to systemic crises. Given the business risk of the hedge fund strategy, it is possible to determine the maximum level of Financial Leverage that the strategy is able to support ex ante. If there are a large number of hedge funds that take the leverage close to the maximum level, despite the different strategy, the risk of systemic crisis rises. This paper uses both empirical data on Hedge Fund strategy index and a Merton model approach to determine the maximum level of financial leverage. This work determines the credit spread that enhances the reward/risk ratio of the single strategy, exploring the consequences of a sudden increase in credit spreads. Finally, given a market risk factor such us the equity risk, it is possible to demonstrate that financial leverage increases the correlation among the strategies and with the markets. If the market registers severe drawdown, the hedge fund industry does not achieve the absolute return objective. In conclusion, one of the most known characteristic of the Hedge Fund Industry – the use of the leverage – can became the main cause of the industry difficulties. It can jeopardize even the future of the industry