When There is No Place to Hide - Correlation Risk and the Cross-Section of Hedge Fund Returns
The University of Chicago; Imperial College Business School; Centre for Economic Policy Research (CEPR)
Imperial College Business School; University of Oxford, Oxford-Man Institute of Quantitative Finance
Swiss Finance Institute; University of Lugano
March 28, 2013
Using a novel dataset of correlation swap quotes, we study the relation between correlation risk, hedge fund characteristics and their risk-return profile. First, we find that hedge funds' ability to create market neutral returns is often associated with a significant exposure to correlation risk. Second, exposure to correlation risk explains large biases in risk-adjusted performance rankings between funds, with respect to benchmark valuation frameworks with no correlation risk dimension. Third, we estimate a significant negative market price of correlation risk, which explains a large part of the cross-section of hedge fund excess returns with their correlation risk exposure. Finally, we detect a pronounced nonlinear relation between correlation risk exposure and the tail risk of hedge fund returns.
Number of Pages in PDF File: 46
Keywords: Stochastic Correlation and Volatility, Hedge Fund Performance, Optimal Portfolio Choice
JEL Classification: D9, E3, E4, G11, G14, G23working papers series
Date posted: July 15, 2010 ; Last revised: April 1, 2013
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