![]() Xu et al (2011) report similar results, indicating that the large-scale redemptions and closure of nearly 1500 hedge funds during the 2008 crisis represented a downturn not seen since the expansion of hedge funds in the 1990s. Gregoriou and Lhabitant conclude that ‘greed, combined with leverage, misaligned incentives, and complacency, caused the 2008 crisis’. For example, a relative-value style fund typically uses a leverage level of 5–10 times, whereas fixed-income arbitrage or statistical arbitrage styles use leverage levels of 10–20 times. Different hedge fund styles use different levels of borrowing. In their analysis of the financial crisis, leverage is identified to be one of the main causes. In addition, they report that the number of hedge funds that died in 2008 was close to 30 per cent of the overall universe of hedge funds. Gregoriou and Lhabitant (2011) argue that one of the causes for the crisis is the increased use of leverage when hedge fund returns were disappointing. The recent financial crisis 2007–2008 has many examples illustrating the above phenomenon. The result can be that a hedge fund manager may increase leverage and shift allocation to riskier instruments, as taking on more risk could result in a better return and increase the probability that the hedge fund survives. In extreme situations when the hedge fund might incur a substantial loss, the risk preferences of the managers may change. Hedge fund management can serve as an illustration for such behavior. When facing a loss, a loss averse investor may switch from a risk-averse strategy to a risk-seeking strategy in order to avoid the loss. Loss aversion is a well-known phenomenon in behavioral finance, representing an investor’s greater aversion to losses than preference for corresponding gains.
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