Hedge funds are known to produce significantly positive OLS-regression alphas. I test whether the positive OLS alpha could be consistent with a rational outcome from a peso problem. To test this, I construct a two-state regime-switching model which can capture a potential future crash state with a small probability. By applying the time-series version of testing a peso problem, I provide evidence that an ex-ante rational expectation of zero alpha can frequently produce an expost positive OLS alpha. My results suggest that the positive OLS alpha in hedge funds can be a rational outcome.​

Keywords: Hedge Funds; Alpha; Peso Problem; Regime-Switching; Crash Risk

JEL Classification Codes: G11; G12; G14; G23