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Abstract:
We suggest an empirical model to analyze the investment style of individual hedge funds and funds of funds. Our approach is based on a mixture of the style analysis approach suggested by Sharpe (1988), the factor push approach used in stress testing, and historical simulation. An interesting and straightforward extension of this model is the estimation of value-at-risk (VaR) figures. This extension is tested using a very intuitive implementation over a large sample of 2,934 hedge funds over the 1994-2000 period. Both the in-the-sample and the out-of-sample results suggest that the proposed approach is useful and may constitute a valuable tool for assessing the investment style and risk of hedge funds.

Hedge funds, value at risk, style analysis

Abstract:
There are many benefits to investing in hedge funds, particularly when using a diversified multi-strategy approach. Over the recent years, multi-strategy funds of hedge funds have flourished and are now the favorite investment vehicles of institutional investors to discover the world of alternative investments. More recently, funds of hedge funds that specialize within an investment style have also emerged. Both types of funds put forward their ability to diversify risks by spreading them over several managers. However, diversifying a hedge fund portfolio also raises a number of issues, such as the optimal number of hedge funds to really benefit from diversification, and the influence of diversification on the various statistics of the return distribution (e.g. expected return, skewness, kurtosis, correlation with traditional asset classes, value at risk and other tail statistics). In this paper, using a large database of hedge funds over the 1990-2001 period, we study the impact of diversification on naively constructed (randomly chosen and equally weighted) hedge fund portfolios. We also provide some insight into style diversification benefits, as well as the inter-temporal evolution of diversification effects on hedge funds.

Hedge funds, diversification

Abstract:
The last two decades have seen the development of a profusion of theoretical models of the term structure of interest rates. This study provides a general overview and a comprehensive comparative study of the most popular ones among both academics and practitioners. It also discusses their respective advantages and disadvantages in terms of bond and/or interest rate contingent claims continuous time valuation or hedging, parameter estimation, and calibration. Finally, it proposes a unified approach for model risk assessment. Despite the relatively complex mathematics involved, financial intuition rather then mathematical rigour is emphasised throughout. The classification by means of general characteristics should enable the understanding of the different features of each model, facilitate the choice of a model in specific theoretical or empirical circumstances, and allows the testing of various models with nested as well as non-nested specifications.

Interest rates, term structure models

Abstract:
For more than seventeen years, Bernard Madoff operated what was viewed as one of the most successful investment strategies in the world. This strategy ultimately collapsed in December 2008 in what financial experts are calling one of the most detrimental Ponzi schemes in history. Many large and otherwise sophisticated bankers, hedge funds, and funds of funds have been hit by his alleged fraud. In this paper, we review some of the red flags that any operational due diligence and quantitative analysis should have identified as a concern prior to investing. We highlight some of the salient operational features common to best-of-breed hedge funds, features that were clearly missing from Madoff's operations.

hedge funds, fraud case, due diligence

Abstract:
Hedge fund indices have grown in numbers over the recent years and made their presence widespread through a number of providers. Assets linked to hedge fund indices currently exceed $12 billion, and the debate is now focusing on whether they should be considered as eligible assets for UCITS III funds. The consequences of a positive or negative answer from regulators are extremely important. In particular, a positive answer would imply that any non-approved offshore hedge fund can be indirectly distributed to any retail investors via an UCITS III vehicle, as long as this fund belongs to a hedge fund index. The problem is that existing hedge fund indices are fundamentally different from indices of traditional assets.

In this paper, we review non-investable hedge fund indices, the various steps of their construction and the numerous performance biases that affect their returns. These biases are so important that in our view, the majority of existing hedge fund indices are not representative of the hedge fund universe - at best, they represent a biased sample of funds that have agreed to report to a database or an index provider. The case of the so-called investable hedge fund indices, which are often presented as an alternative to actively managed funds of hedge funds, is not much better. Our observations reveal that existing investable indices are less representative of the hedge fund universe and more biased than their non-investable cousins. They are, in essence, funds of hedge funds managed according to arbitrary rules and primarily designed to support high-fee tracking products.

As a result of their numerous biases, lack of representativity and/or construction, our view is that existing hedge fund indices do not fulfill the three basic criteria required to become UCITS III eligible - sufficient diversification, ability to serve as an adequate benchmark and appropriate publication. We therefore suggest excluding them from the list of UCITS III eligible assets. Of course, in the future, this position could be revised once quality hedge fund indices are available and fulfil the aforementioned three basic criteria.

hedge funds, UCITS, regulation, indices

Abstract:
This paper presents an overview of the theories underlying the major portfolio performance measurement models, with an empirical application to assess the market timing and stock-picking abilities of an exhaustive sample of 60 Swiss-equity investment funds over the 1977-1999 period. Regardless of the benchmark portfolio or the performance measurement model, we find no evidence that Swiss-equity mutual funds, either individually or as a whole, provide investors with superior stock selection or market timing relative to a passively managed benchmark portfolio. We also found a negative correlation between selectivity and timing results. Finally, the influence of asset size, funds age and management fees are considered as an explanation of the results. In contrast to traditional methods of calculating the expected costs of risk in banks, the calculation with rating transition matrices includes the possible temporal courses of credit defaults and default probabilities and leads to more precise results. In our paper, we analyze some structural properties of rating transition matrices with regard to future expected portfolio structures, and we derive formulas for the calculation of the net present value with the help of rating transition matrices. From a methodological point of view, the approach is a straightforward refinement of traditional approaches of calculating costs of risk.

Abstract:
This paper presents an overview of the theories underlying the major portfolio performance measurement models, with an empirical application to assess the market timing and stock-picking abilities of an exhaustive sample of 60 Swiss-equity investment funds over the 1977-1999 period. Regardless of the benchmark portfolio or the performance measurement model, we find no evidence that Swiss-equity mutual funds, either individually or as a whole, provide investors with superior stock selection or market timing relative to a passively managed benchmark portfolio. We also found a negative correlation between selectivity and timing results. Finally, the influence of asset size, funds age and management fees are considered as an explanation of the results.

Abstract:
We study the empirical link that exists between investment and cash flow in the Swiss financial market. We follow the standard method introduced by Fazarri, Hubbard and Peterson (1988), with two major improvements. The firms' classification method is dynamic, and the estimation procedure allows for testing differences between groups. We pay particular attention to two aspects: information asymmetry and the business cycle. First, due to local particularities, Swiss firms can be differentiated according to precise measures of asymmetric information, leading to a non-ambiguous interpretation of the link between investment-cash flow sensitivities and the intensity of financial constraints. Second, the sample is split into two sub-periods: a boom and a recession period.

Abstract:
In this paper, we propose a general methodology to analyse model risk for discount bond options within a unified Heath, Jarrow, Morton (1992) framework. We illustrate its applicability by focusing on the hedging of discount bond options and options portfolios. We show how to decompose the agent's "model risk" profit and loss, and emphasize the importance of the position's gamma in order to control it. We further provide mathematical results on the distribution of the forward profit and loss function for specific Markov univariate term structure models. Finally, we run numerical simulations for naked and combined option's hedging strategies in order to quantify the sensitivity of the forward profit and loss function with respect to the volatility of the forward rate curve, the shape of the term structure, and the characteristics of the position being hedged.

model risk, interest rate risk, Heath-Jarrow-Morton

Abstract:
This paper focuses on pricing and hedging options on a zero-coupon bond in a Heath?Jarrow?Morton (1992) framework when the value and/or functional form of forward interest rates volatility is unknown, but is assumed to lie between two fixed values. Due to the link existing between the drift and the diffusion coefficients of the forward rates in the Heath, Jarrow and Morton framework, this is equivalent to hedging and pricing the option when the underlying interest rate model is unknown. We show that a continuous range of option prices consistent with no arbitrage exist. This range is bounded by the smallest upper-hedging strategy and the largest lower-hedging strategy prices, which are characterized as the solutions of two non-linear partial differential equations. We also discuss several pricing and hedging illustrations.