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Abstract:
In a complete, arbitrage-free securities market, the value of a discount bond is modeled in terms of the pricing kernel and the transition density function of the spot interest rate process. The prices of discount bonds are taken from the current term structure of interest rates, and the transition density function is estimated from historical term structure data, using both parametric and nonparametric techniques. The pricing kernel and associated prices of Arrow-Debreu securities are then determined. The resulting Arrow-Debreu prices have two merits: they are consistent with the current term structure of interest rates, and therefore arbitrage-free, and, in addition, they embody the observed historical behavior of the term structure.

Abstract:
The growth in hedge fund has in part been due to their historical return to risk performance. Concern, however, has been expressed that one reason for the superior return to risk tradeoff for hedge funds, is that, unlike traditional mutual funds, hedge funds often trade in illiquid securities and may have the ability to smooth prices such that reported volatility and systematic risk are less than actual volatility and systematic risk. In this paper we show that previous research which has used the lagged values of S&P 500 returns to test the potential impact of stale prices may simply reflect a unique historical anomaly in the relationship between hedge fund returns and lagged returns on the S&P 500. While price smoothing may still exist in various hedge fund strategies, we show that the empirical results presented in previous papers have an alternative explanation that is unrelated to stale prices or data smoothing.

Hedge Funds, Stale Prices, Data Smoothing

Abstract:
This article assesses the effectiveness of a long collar as a protective strategy. We examine the risk/return characteristics of a passive collar strategy on the Powershares QQQ trust exchange traded fund (Ticker: QQQQ) from March 1999 to March 2008 and find that, over this time period, a 6-month put/1-month call collar provides far superior returns to the buy and hold QQQ strategy at about 1/3 of the volatility. Since returns from protective strategies are not normally distributed, we use both Leland alpha and the Stutzer index to measure risk-adjusted performance. In the analysis we consider a number of implementations of a long collar strategy, where for each strategy the impact of bid/ask spreads on the strategy's performance are taken into account. We vary the moneyness of the puts and calls as well as the time to maturity of the puts to create a total of 27 different implementations, and create indices to represent the returns to each of these collar implementations. To examine the collar's performance in different market environments, the time period is further segmented into two sub-periods, an early period which is generally favorable to the collar and a later period which is clearly unfavorable to a collar strategy. Most implementations significantly outperform the QQQ in the overall period, as well as in the favorable period. All of the implementations under perform the QQQ in the unfavorable (to the collar) period. However, all of the implementations of the collar exhibit lower risk than the buy and hold QQQ in all of the periods. The magnitude of the risk reduction of the collar is quite impressive.

collar, options, qqq, qqqq, etf, strategy, portfolio, protection, insurance, trading, option, exchange, traded, fund, funds

Abstract:
This paper uses a set of return-based factors to test for market (return and volatility) timing ability of Commodity Trading Advisors (CTAs). Unlike previous research, we use return-based factors that are related to the markets in which most CTAs trade. This leads to a higher explanatory power for our multifactor model. Our approach allows us to test for the presence of market timing in multiple markets, and, therefore, we are able to identify the markets in which CTAs have market timing ability. We find that systematic CTAs are in general better at market timing than discretionary CTAs, with the latter having slightly better overall risk-adjusted performance during our study period: Jan 1994 to Dec 2004. We suspect that this is caused by higher turnover of portfolios of discretionary CTAs leading to frequent changes in their factor exposures that cannot be captured through monthly observations. We show that CTAs display a negative relationship between market timing ability and security selection, and as a group CTAs generate their returns mainly from market timing, rather than security selection ability.

CTA, discretionary, systematic, market timing, volatility timing

Abstract:
This paper examines the effects of deviations from random walk in asset prices on option prices. Several approaches can be taken to model asset price processes as non-random walk processes. We choose to model the equity prices as fractional Brownian motions (FBM). Though FMB is not the most ideal model for the behavior of security prices, it offers many advantages namely it allows for short-term and long-term memory in asset prices. This paper uses Monte Carlo simulations to determine option prices under the assumption that equity prices follow FBM. The simulated prices and their implied volatilities are then compared to prices that one would obtain using the Black-Scholes-Merton option price model. The results show that even a small deviation from random walk can have a significant impact on option prices. The volatilities implied by the simulated prices generally increase as the call options go deeper into the money when security prices have short-term memory. In other words, short-term memory in security prices contributes to the presence of the so-called "smile" effect in implied volatilities.

Abstract:
Using daily returns on a set of hedge fund indices, we study (i) the properties of the indices' conditional density functions and (ii) the presence of asymmetries in conditional correlations between hedge fund indices and other investments and between hedge fund indices themselves. We use the SNP approach to obtain estimates of conditional densities of hedge fund returns and then proceed to examine their properties. In general, a nonparametric GARCH(1,1) model appears to provide the best fit for all strategies. We find that the conditional third and fourth moments are significantly affected by changes in the current volatility of returns on hedge fund indices. We examine changes in the conditional probability of tail events and report significant changes in the probability of extreme events when the conditioning information changes. These results have important implications for models of hedge fund risk that rely on probability of tail events. We formally test for the presence of asymmetries in conditional correlations to determine if there is contagion between hedge funds and other investments and between various hedge fund indices in extreme down markets versus extreme up markets. We generally do not find strong evidence in support of asymmetric correlations.

Abstract:
Using daily returns on a set of hedge fund indices, we study (i) the properties of the indices' conditional density functions, (ii) the presence of asymmetries in conditional correlations between hedge fund indices and other investments and between hedge indices themselves, and (iii) the presence of market timing skills in the indices. We use the SNP approach to obtain estimates of conditional densities of hedge fund returns and then proceed to examine their properties. In general, a nonparametric GARCH(1,1) model appears to provide the best fit for all strategies. We find that the conditional third and fourth moments are significantly affected by changes in the current volatility of returns on hedge fund indices. We also examine changes in the conditional probability of tail events and report significant changes in the probability of extreme events when the conditioning information changes. These results have important implications for models of hedge fund risk that rely on probability of tail events. We formally test for the presence of asymmetries in conditional correlations to determine if there is contagion between hedge funds and other investments and between various hedge fund indices in extreme down markets versus extreme up markets. We do not find strong evidence in support of asymmetric correlations between hedge funds and other investments, while we find evidence in support of asymmetric correlations between some hedge fund indices. Finally, we find strong evidence supporting the presence of market timing skills in these indices. However, we argue that our findings are more likely to be because of long-volatility positions held by the managers rather than because of their market timing abilities. Further, we claim that the presence of option-type returns as explanatory variables are not likely to correct for this problem. We use market timing results concerning returns on a simulated portfolio to support this conclusion.

Hedge funds, contagion, conditional volatility, skewness, market timing

Abstract:
We examine the impact of the optionality of performance fee on the risk-shifting behavior of hedge fund managers. Since performance fees earned by hedge fund managers have the characteristics of a call option, the moneyness of the option may have an impact on the risk-taking behavior of managers. We seek to determine if hedge fund managers adjust their fund's volatility in reaction to the moneyness of the performance option. We find that managers increase their fund's volatility when the compensation option is "out of the money". We find that managers of less liquid, small or young funds do not display that type of risk-shifting behavior. Further, we report that the longer a manager does not collect performance fees, the more likely she is to increase the fund volatility in the hope of increasing the fund value and thus collecting performance fees. Finally, we find that compared to absolute performance, relative performance has a stronger influence on the risk-taking behavior of hedge fund managers. This result is not uniform over all strategies.

Risk-taking, managerial incentives, hedge funds

Abstract:
The hedge funds industry has evolved tremendously in recent years. According to the CASAM CISDM Industry Report, assets under management in hedge funds had grown from less than USD 50 billion at the end of 1990 to over USD 2.1 trillion at the end of 2007. However, assets managed by hedge funds have dropped significantly since then to less than USD 1.3 trillion at the end of June 2009. Since hedge funds have been marketed to investors as risk diversifiers in addition to being return enhancers, the actual “manager skill” or “value added” or “alpha” deserves careful examination at this time. In this article we examine the validity of the concept of “alpha”. We use both single factor (Jensen’s alpha) and multi-factor models to estimate alpha. We use three different indices with vastly differing construction processes and compositions. Unlike most previous studies, we choose specific factors for each strategy. Our results show that strategy specific factors had greater explanatory power but were insufficient to explain the wide variety of fund exposures. Multi-factor models were an improvement but nevertheless insufficient. We conclude that quantitative analysis is generally insufficient when it comes to measuring manager skill (alpha). Manager skill or “alpha” should be determined in a qualitative setting as well. Unfortunately, there is no measure that encompasses both quantitative and qualitative attributes although hedge fund ratings agencies have made some headway in this regard.

hedge fund performance, alpha financial credit crisis

Abstract:
This paper examines the impact of sovereign credit rating change announcements on the CDS spreads of the event countries, and their spillover effects on other emerging economies' CDS premiums. In contrast to previous work, we find that positive events have a more consistent impact on sovereign CDS markets in the short period surrounding the event, and are more likely to spill over to other emerging markets, whereas negative events have a higher probability of being predicted by the CDS premium. The transmission mechanisms for positive events are the common creditor and competition in trade markets.

CDS markets, CDS spreads, credit rating events, emerging markets, spillover effects

Abstract:
Hedge fund performance and risk measurement continues to present intriguing challenges to both academics and practitioners. Risk-return measures that are solely based on historical return series tend to provide limited information and the marginal new information revealed by another quantitative measure tends to be small, and approaches zero once three or more measures are considered. In this article we will examine the ris exposures and performance characteristics of Amaranth Advisors LLC. Amaranth Advisors LLC was created in 2000 as a multi-strategy hedge fund. Beginning operations with approximately $600 million in capital, it sought to employ a diverse group of arbitrage trading strategies particularly featuring convertible bonds, mergers and utilities. In 2002, Amaranth added energy commodity trading to its slate of strategies with JP Morgan Chase clearing its commodity trades. On August 4, 2006 NYMEX examined Amaranth’s positions and calculated that Amaranth held about 51% of the open interest in the September natural gas futures contract which would expire at the end of the month. NYMEX decided that this was too large and on August 8 NYMEX compliance officials notified Amaranth of their concerns. Amaranth complied with NYMEX’s directions and subsequently reduced its September and October positions. However, at the same time Amaranth increased its positions in September and October ICE contracts such that their overall positions in natural gas rose. The events that followed in late August and September led to huge losses with Amaranth losing significant value.

Abstract:
This paper tests for contagion in emerging debt markets following Russia and Argentina’s government defaults. Using techniques that have been previously suggested for contagion tests in stock markets we find that debt and stock markets respond differently to financial crises. Volatilities and correlations do not increase significantly during default episodes and no evidence supporting spillover effects is found. However, we find evidence of contagion in extreme returns during both crisis periods as well as in the entire sample period. We conclude that contagion in emerging bond markets is more likely driven by their high linkages than by crisis episodes.

contagion, credit events, emerging markets, sovereign debt, volatility spillover

Abstract:
We examine the interaction between various managerial incentives and shifts in risk assumed by hedge fund managers. With a more comprehensive and flexible proxy for hedge fund's compensation option, we are able to explore the impact on shift of risk-taking over a window of three years from "monetary incentive" which comes from asymmetric compensation structure and "impatience incentive" which arises as managers get anxious to do something facing unsatisfactory fund performance. We find that "monetary incentive" affects managers in certain strategies (mostly equity hedge) with certain fund characteristics (medium-sized, medium-aged, high management fees). "Impatience incentive" is found to play a consistent role in shift of risk-taking. We also find evidence for the impacts of "survival incentive" and "prestige incentive" to be consistent with the literature, that a fund has incentives to reduce volatility even with poor performance when survival pressure is eminent. Hedge funds also shift their risk-taking in response to relative performance in a tournament setting: they increase volatility in response to poor relative performance and do the reverse to lock in the good relative performance. Due to the high level of heterogeneity in hedge fund managers, liquidity level varies across strategies. The less liquid strategies like convertible arbitrage, distressed securities, are constrained to shift their risk-taking within a one-year period. The more liquid strategies, like equity hedge, however, as a group are found to shift their risk-taking significantly more than the less liquid group.

managerial incentive, risk-taking, performance

Abstract:
Large orders, particularly from institutions, are quite common these days and hence there is interest to know if institutional trading has any bearing on the price effect associated with large trades. Recent empirical studies contradict earlier evidence of negative price effect on selling large blocks and find no price effect associated with large trades. Existing theoretical framework suggests a monotonic and increasing adverse price effect for large trades, where the motivation for a large trade is private information. We model a trading system where pure information, information-liquidity, and pure liquidity traders trade small and large sizes. The pure information traders strategically choose an order size. Institutions trade only large sizes because of their low execution costs for large trades; they are information-liquidity traders whose ability to use an information signal to determine their trades is subject to a binding liquidity constraint. We show that in such a market a separating equilibrium where trade size is informative does not exist and hence there is no price effect for large trades. Trade size may be revealing only if there is a buy sell asymmetry (large buy size is not equal to large sell size) or the corresponding price effect is asymmetric (price effect due to a large buy is not equal to that of a large sell). Further for a pooling equilibrium to exist, where trade size is not informative, the width of the market denoted by the ratio of order size (large size/small size) needs to be small, while the shallowness (inverse depth) of the market denoted by the ratio between pure information and institutional trades and the information signal needs to be stronger (higher). Our results on bid and ask prices and spread confirm recent empirical evidence on price effect of large and institutional trades found in the literature.

Information asymmetry, Sequential equilibrium, Order size, Security price, Bid-ask spread, Institutions

Abstract:
With a new proxy for the compensation option to hedge funds management, we explore the managerial incentives and risk-taking behavior for an extended sample of hedge funds. We focus on the incentives in response to the compensation option as discussed in Goetzmann, Ingersoll, and Ross (2003), and to relative performance in a 'tournament' as proposed by Brown, Harlow, and Starks (1996). We find that managers do respond to the "moneyness" of their compensation option and the length of time a fund has stayed under-water by shifting their volatility strategies. We find that size, age, as well as management fee level all play a role in affecting this response. On the other hand, funds are also found to respond to relative performance as described in the 'tournament' theory.

managerial incentive, option

Abstract:
This article uses bond market data to empirically test the asset pricing model of Kazemi (1992). According to this model the rate of return on a long-term, pure-discount, default-free bond will be perfectly correlated with changes in the marginal utility of the representative investor. The covariability between financial asset returns and returns on such a bond can therefore serve as a measure of the riskiness of assets. The aim of this study is to determine whether the model can explain cross-sectional differences in the monthly returns of bonds with different maturity dates. We estimate and test the restrictions imposed by the model on returns of default-free bonds, while allowing the conditional distribution of bond returns to be time varying. The model is rejected during the full sample period (1973-1995) and the subperiod (1973-1980) when the Federal Reserve's focus is on interest rates, while the model is not rejected during the subperiod (1981-1995) when the Federal Reserve's focus is on money supply.