Effect of market liquidity on distressed debt hedge funds

In this paper I investigate the returns of distressed debt hedge funds. Historically, these types of investors managed to outperform the market by a significant margin. I examine if traditional risk factors combined with a liquidity risk factor are able to capture the common variation in the returns of the distressed debt hedge funds. A liquidity proxy is constructed by a Nelson-Siegel model with time-varying loading parameter and volatility. The time-varying volatility is modeled by a GARCH process and is used as a proxy for the liquidity in the market. Using the Fama-Macbeth procedure, I then construct a liquidity factor which is being used in the risk factor model. I find that there is significant evidence that the liquidity factor is able to explain part of the variation in the returns of distressed debt hedge funds. Moreover, the factors altogether explain a significant part of the common variation in the returns of distressed debt hedge funds.