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Abstract:
This paper proposes a methodology to analyze the implications of the Advanced Measurement Approach (AMA) put forward by the Basel II Accord for the assessment of operational risk. We develop an integrated procedure for the construction of the distribution of aggregate losses, using internal and external data. It is illustrated on a 2x2 matrix of two selected business lines and two event types, drawn from a database of 3000 losses obtained from a large European banking institution. For each cell, the method calibrates three truncated distributions functions for the body of internal data, the tail of internal data, and external data. When the dependence structure between aggregate losses and the non-linear adjustment of external data are explicitly taken into account, the regulatory capital computed with the AMA method is substantially lower than with less sophisticated approaches, although the effect is not uniform. We then estimate the effects of operational risk management actions on bank profitability, through a measure of RAROC adapted to operational risk. The results suggest that substantial savings can be achieved through active management techniques, although the effect of a reduction of the frequency or severity of operational losses depends on the calibration of the aggregate loss distributions.

Basel 2, operational risk, extreme value theory, external data, RAROC

Abstract:
This paper tests the performance of 2894 hedge funds in a time period that encompasses unambiguously bullish and bearish trends whose pivot is commonly set at March 2000. Our database proves to be fairly trustable with respect to the most important biases in hedge funds studies, despite the high attrition rate of funds observed in the down market. We apply an original ten-factor composite performance model that achieves very high significance levels. The analysis of performance indicates that most hedge funds significantly out-performed the market during the whole test period, mostly thanks to the bullish sub-period. In contrast, no significant under-performance of individual hedge funds strategies is observed when markets headed south. The analysis of persistence yields very similar results, with most of the predictability being found among middle performers during the bullish period. However, the Market Neutral strategy represents a remarkable exception, as abnormal performance is sustained throughout and significant persistence can be found between the 20% and 69% best performers in this category, probably thanks to an extreme adaptability and a very active investment behavior.

Hedge fund, hedge funds, carhart, capocci, hubner, performance, persistence, decile analysis

Abstract:
The new Basel II Capital Accord incorporates an explicit capital requirement for operational risk into its proposed capital framework. Unfortunately, although the advanced approaches for the measurement of operational risk evolve rapidly, the absence of reliable internal operational loss databases in many financial institutions is likely to hinder the use of these models. As there is a much greater variety in credit risk modeling approaches, this paper explores the possibility of applying a properly modified version of CreditRisk+, one of the most popular credit risk models, to operational loss data. To assess its usefulness, our this paper investigates the fitting quality of an adapted version of CreditRisk+ on simulated databases generated from three known distributions with thin, medium and fat tails. Our results show that our adapted model, OpRisk+, is able to work out very satisfying Values-at-Risk at 95% level as compared with a lower bound issued from the IMA approach of Alexander (2003), and with the sophisticated approach advocated by Chapelle, Crama, Huebner and Peters (2005). The OpRisk+ approach proves to be extremely worthy in the case of small samples, where more complex methods cannot be applied. This suggests that OpRisk+ can be used in many instances to fit the body of the distribution of operational losses up to the 95% percentile, and Extreme Value Theory or external databases should be used beyond this quantile.

Operational Risk, Value-at-Risk, CreditRisk+, AMA

Abstract:
This paper presents a generalization of the Treynor ratio in a multi-index setup. The solution proposed in this paper is the simplest measure that keeps Treynor's original interpretation of the ratio of abnormal excess return (Jensen's alpha) to systematic risk exposure (the beta) and preserves the same key geometric and analytical properties as the original single index measure. The Generalized Treynor ratio is defined as the abnormal return of a portfolio per unit of weighted-average systematic risk, the weight of each risk loading being the value of the corresponding risk premium. Each risk premium is normalized to ensure the unit corresponding beta of the benchmark portfolio.

Asset pricing, portfolio management, funds performance, Jensen's alpha, Treynor ratio

Abstract:
This paper performs a census of the 101 performance measures for portfolios that have been proposed so far in the scientific literature. We discuss their main strengths and weaknesses and provide a classification based on their objectives, properties and degree of generalization. The measures are categorized based on the general way they are computed: asset selection vs. market timing, standardized vs. individualized, absolute vs. relative and excess return vs. gain measure. We show that several categories have been exhausted while some others feature very heterogeneous ways to assess performance within the same sets of objectives.

performance measurement, portfolio, funds, Sharpe, alpha, Treynor, market timing

Abstract:
We extend the class of structural models of credit derivatives by allowing for multiple debt issues. Since firms default on all of their obligations, total debt is instrumental in the likelihood of default and therefore in credit derivatives valuation. We use a mono-factor interest rate model where the exponential default frontier is based on total debt and is made coherent with observed bond prices. Analytical formulae are derived for credit default swaps, total return swaps (both fixed-for-fixed and fixed-for-floating), and credit risk options. Simulations document that credit derivatives prices are affected in a non-trivial way by terms of debt other than those of the reference obligation.

credit derivatives, credit risk, structural model

Abstract:
This paper analyzes the impact of corporate international diversification (CID) on domestic and world betas through the notion of psychic distance between countries. Using a large European sample of 598 firms, our findings indicate that this dimension significantly influences corporate risk exposure. By isolating three additive components of the Foreign Sales Ratio (FSR), we obtain the most significant results by geographically partitioning the sample, provided that firms are further classified by sector. Our framework sheds new light on how the CID of firms belonging to Sweden and the United Kingdom, as well as the Consumer Cyclical, Consumer Non-Cyclical and Information Technology sectors, sometimes can reduce and sometimes increase firm betas.

Internationalization, Psychic Distance, Asset Pricing

Abstract:
This paper analyzes the impact of corporate international diversification (CID) on the cost of equity through the notion of psychic distance between countries. Using a large European sample of 598 firms, our findings indicate that this dimension significantly influences corporate risk exposure. By isolating three additive components of the Foreign Sales Ratio (FSR), we obtain the most significant results by geographically partitioning the sample, provided that firms are further classified by sector. Our framework sheds new light on the CID of firms belonging to Finland, Sweden and the United Kingdom, as well as the Consumer Cyclical, Consumer Non-Cyclical and Information Technology sectors.

Internationalization, Psychic Distance, Asset Pricing

Abstract:
This paper revisits the traditional return-based style analysis (RBSA) in presence of time-varying exposures and errors-in-variables (EIV). We first apply a selection algorithm using the Kalman filter to identify the more appropriate benchmarks for the analysed fund return. Then, we compute their corresponding higher moment estimated errors-in-variables, i.e. the measurement error series introducing the (cross) moments of order three and four. We adjust the selected benchmarks by subtracting their higher moments estimated EIV from the initial return series, to obtain an estimate of the true uncontaminated benchmarks. We finally run the Kalman filter on these adjusted regressors. Analysing EDHEC alternative indexes styles, we show that this technique improves the factor loadings and permits to identify more precisely the return sources of the considered hedge fund strategy.

style analysis, Kalman filter, errors-in-variables, measurement errors, higher moment estimators, hedge funds

Abstract:
In spring 2000, three events - two political statements by Bill Clinton and Tony Blair and a breakthrough announcement by Celera Genomics - had a major impact on biotechnology stocks. We analyze their effects over a comprehensive set of biopharmaceutical companies, using a composite return-generating model with an industry-specific patent-based factor. Our results show that stocks can be clustered according to their responsiveness to political and scientific events. Furthermore, we emphasize different impacts on the market value of intangible assets for each cluster, suggesting that growth options are valued with different criteria for therapeutics, and technology-based subsectors.

Abstract:
In spring 2000, three clustered events, two political statements by Bill Clinton and Tony Blair and a breakthrough announcement by Celera Genomics, had altogether a tremendous impact on biotechnology stocks. Their effects are analyzed over a comprehensive set of biopharmaceutical companies, using a composite return-generating model with an industry-specific patent-based factor. The analysis shows that stocks can be grouped depending on their responsiveness to political and scientific events. Furthermore, in-depth examination of event returns reveals that political events produced more favorable effects in sectors where patent protection has the greatest market value, contrarily to the impact of the scientific announcement.

Event study, biotechnologies, patent valuation

Abstract:
Empirical research on the performance of managed portfolios with multi-index models has only been using the alpha as performance metric. This paper assesses the ranking abilities of the alpha, the Information Ratio and the Generalized Treynor Ratio proposed by Hübner (2005) on a sample of directional mutual funds. The quality of a ranking scheme is examined along two dimensions: precision and stability. A precise measure will produce the same ranking of funds with alternative benchmark portfolios. A stable measure will produce the same ranking with different model specifications. For both criteria, the Generalized Treynor Ratio provides superior results, especially when nonparametric concordance measures are used.

Performance measurement, multi-index models, mutual funds performance, alpha, information ratio, Treynor ratio

Abstract:
This paper presents an equilibrium asset pricing model where, unlike in the CAPM, returns distributions and investors' utility functions are both unspecified. Rather, only the centered moments up to order four of the unknown unconditional distribution of returns can be observed and investors unanismously associate a security's measure of riskiness to the time required for its mean return to converge around its expectation with a specified tolerance. The measurement of this horizon is obtained through the use of Chebyshev-type inequalities. The input parameters for the definition of risk horizon can be calibrated using the term structure of interest rates. Investors may let alone differ in their attitude vis-a-vis risk horizon for any level of expected return, but they may also exhibit various sensitivities with respect to each moment of the returns distributions. This model overcomes two important weaknesses of parametric multi-moments asset pricing models. First, it does not imply moment preferences, respecting Brockett and Kahane's (1992) theoretical finding. Furthermore, provided that the measurement of risk horizon largely emphasizes catastrophic events, investors may also not have any incentive to diversify their portfolio, which was already found by Simkowitz and Beedles (1978). At equilibrium, the horizon-based capital market line displays a nonlinear, but monotonically increasing relationship between the expected returns of portfolios held by rational investors and the risk horizon of their selected efficient portfolio. If two-funds separation does not obtain, idiosyncratic risk can even be priced. If diversification holds, the model yields a three-factor linear equation for the determination of individual securities returns, involving their covariance, coskewness and cokurtosis with the single market portfolio returns. In spite of its inclusion in the model, the riskless rate is not the intercept of this pricing equation, while all risk premia are nonlinear functions of the first four moments of the market porfolio returns distribution. By proper restrictions on the parameters characterizing investment horizon, the CAPM, the zero-beta CAPM and the Kraus-Litzenberger (1976) model are nested in this nonparametric model, with different degrees of freedom depending on whether they rest upon distribution-based or utility-based assumptions. Considering Value-at-Risk (VaR) as a market-wide measure of risk would also be compatible with this approach.

equilibrium asset pricing, multi-moment, skewness, kurtosis, nonparametric risk, horizon, Chebyshev's inequality

Abstract:
Green (1984) demonstrates in a one-period setting that convertible debt can eliminate the asset substitution problem. However, in a multi-period setting the terms of the convertible issue will in general be set before the specific asset substitution opportunity presents itself. This leaves room for a strategic non-cooperative game between shareholders and convertible debtholders. We show that two risk-shifting scenarios arise as attainable Nash equilibria. Pure asset substitution occurs when, despite convertible debtholders not exercising their conversion option, shareholders still find it profitable to shift risk. Strategic conversion occurs when, despite convertible debtholders giving up the conversion option value, they are better off receiving their share of the wealth expropriation from straight debtholders. We use contingent claims analysis and the Black and Scholes (1973) setup to characterize the equilibria. Even when initial convertible debt is endogenously designed so as to minimize the likelihood of risk-shifting equilibria, we show that asset substitution cannot be completely eliminated. Our overall conclusion is that -- in contrast to agency theory's claim -- convertible debt is an imperfect instrument for mitigating shareholders' incentive to increase risk.

Convertible debt, Risk shifting, Non-cooperative game

Abstract:
Many models developed for financial applications turn out to be
utterly meaningless unless one can ensure that the data sets are realistic and internally consistent with the assumptions underlying the model. Our particular use of scenario trees, based on an implied density function retrieved from options prices, enables us to realistically, consistently and flexibly model the distribution of future values of a security.
We illustrate this methodology with a pricing application on a set of put and call options written on the S&P 500 index. The same set of options is used as inputs and outputs so as to verify the ability of the model to preserve initial information, while the application of the results to a broader or to a distinct set of option contracts allows to test its pricing performance. The approach compares very favorably with
Rubinstein's methodology (1994), yielding similar results while
using a more parsimonious set of assumptions.

Abstract:
We examine the ability of the factor model approach to evaluate the performance and persistence of hedge fund returns. In our analysis we incorporate traditional asset based factors as well as an array of new and previously studied option based factors. We provide evidence that there is still much information embedded in option prices, particularly in the implied higher moments, which has not previously been exploited. We utilize the framework of Bakshi, Kapadia and Madan (2003) who identify the prices of the implied variance, skewness and kurtosis contracts, and also propose a new approach to evaluate pseudo-moments using out-of-the-money option prices. These new option based factors increase the explanatory power of the models across all the hedge fund strategies, and provide added information that allows us to better predict persistence in returns.

hedge funds, implied higher moments, performance, persistence

Abstract:
This paper studies the relationship between the recovery rate (RR) and the state of an economy (SE) in the traditional Monte Carlo credit risk model introduced by Li (1999) for the pricing of structured credit derivatives. This effect is significant if we consider extreme tranches of collateralized debt obligations (CDOs), because they are only reached when numerous defaults occur. The objective is to present a simple, intuitive and flexible approach for advanced financial products. The model is applied on a generic cash CDO and on the European iTraxx synthetic CDO index.

CDO, Gaussian Copula, Credit Derivatives, Recovery Rate, State of the Economy, iTraxx

Abstract:
This paper studies the joint impact of smoothing and fat tails on the risk-return properties of hedge fund strategies. First, we adjust risk and performance measures for illiquidity and the non-Gaussian distribution of hedge funds returns. We use two risk metrics: the Modified Value-at-Risk and a preference-based measure retrieved from the linear-exponential utility function. Second, we revisit the hedge fund diversification effect with these adjustments for illiquidity. Our results report similar fund performance rankings and optimal hedge fund strategy allocations for both adjusted metrics. We also show that the benefits of hedge funds in portfolio diversification are still persistent but tend to weaken after the adjustment for illiquidity.

Illiquidity, Non-Gaussian returns, Hedge fund performance, Modified Value-at-Risk, Portfolio diversification

Abstract:
Using the unique database of 990 VC-backed Belgian firms we study whether compatibility between corporate and environmental character- istics matter. We adress two questions: (1) Does the joint evolutional pattern of companies, industries, and products affect rates of return?; (2) Does the compatibility between their evolutional stages influence the in- vestment outcome? Panel data analysis shows a significant influence of factor compatibility on returns. Firms yielding similar performances are rather homogeneous, but their factor sensitivity depends on their quantile. Conjoint analysis suggests that certain combinations of factors col- lapse into classifiable situations corresponding to patterns described in the management science literature.

Venture Capital, return, strategy, entrepreneurship, evolution, compatibility

Abstract:
By examining stock market reactions to the announcement of operational losses by financial companies, this paper attempts to disentangle operational losses from reputational damage. Our analysis deals with 154 events coming from the FIRST database of Opvantage. Events occurred between 1990 and 2004 in companies belonging to the financial sector and that are listed on the major European and US Stock Exchanges. Results show significant, negative abnormal returns at the announcement date of the loss, along with an increase in the volumes of trade. In cases of internal fraud, the loss in market value is greater that the operational loss amount announced, which is interpreted as a sign of reputational damage. Negative impact is proportionally greater when the loss amount represents a larger share in the company's net profit.

Operational risk, Reputational risk, Event study

Abstract:
This paper tests the performance of 2894 hedge funds in a time period that encompasses unambiguously bullish and bearish trends whose pivot is commonly set at March 2000. The database proves to be fairly trustable with respect to the most important biases in hedge funds studies, despite the high attrition rate of funds observed in the down market. An original ten-factor composite performance model is applied that achieves very high significance levels. The analysis of performance indicates that most hedge funds significantly outperformed the market during the whole test period, mostly thanks to the bullish subperiod. In contrast, no significant underperformance of individual hedge funds strategies is observed when markets headed south. The analysis of persistence yields very similar results, with most of the predictability being found among middle performers during the bullish period. However, the 'Market Neutral’ strategy represents a remarkable exception, as abnormal performance is sustained throughout and significant persistence can be found between the 20% and 69% best performers in this category, probably thanks to an extreme adaptability and a very active investment behaviour.

Hedge funds, funds of funds, selection bias, abnormal returns, bullish market, bearish market, persistence

Abstract:
This paper extends the Treynor performance ratio for a single index to the case of multiple indexes. The new measure, called the Generalized Treynor Ratio, preserves the same key geometric and analytical properties of the original Treynor Ratio. The Generalized Treynor Ratio is defined as the abnormal return of a portfolio per unit of premium-weighted average systematic risk, normalized by the premium-weighted average systematic risk of the benchmark. Numerical simulations reveal that the portfolio rankings produced with this measure are more precise and more stable than the ones provided by Jensen's alpha and the Information Ratio.

Performance measurement, Jensen's alpha, Information Ratio, Treynor Ratio

Abstract:
Using one of the largest hedge fund databases ever used (2796 individual funds including 801 dissolved), we investigate hedge funds performance using various asset pricing models, including an extension of Carhart's (1997) specification combined with the Fama and French (1998) and Agarwal and Naik (2002) models and a new factor that takes into account the fact that some hedge funds invest in emerging bond markets. This addition is particularly suitable for more than half of the hedge funds categories, and for all funds in general. The performance of hedge funds for several individual strategies and different subperiods, including the Asian Crisis period, indicates limited evidence of persistence in performance but not for extreme performers.

Hedge funds, performance, persistence, Asian crisis, emerging markets, CAPM, dissolution frequenties, survivorship bias, correlation, history bias, total returns