BURKHARD RAUNIG, Austrian National Bank - Economic Studies Division
Email: burkhard.raunig@oenb.co.at
MARTIN SCHEICHER, European Central Bank (ECB)
Email: martin.scheicher@ecb.int

We investigate the risk of holding credit default swaps (CDS) in the trading book and compare the Value at Risk (VaR) of a CDS position to the VaR for investing in the respective firm's equity using a sample of CDS - stock price pairs for 86 actively traded firms over the period from March 2003 to October 2006. We find that the VaR for a stock is usually far larger than the VaR for a position in the same firm's CDS. However, the ratio between CDS and equity VaR is markedly smaller for firms with high credit risk. The ratio also declines for longer holding periods. We also observe a positive correlation between CDS and equity VaR. Panel regressions suggest that our findings are consistent with qualitative predictions of the Merton (1974) model.

RAJNA GIBSON, University of Zurich - Swiss Banking Institute (ISB)
Email: RGIBSON@ISB.UNIZH.CH
SONGTAO WANG, affiliation not provided to SSRN

In this article, we study the effect of liquidity risk on the performance of various hedge fund portfolio strategies. The portfolio strategies in each hedge fund style are formed by incorporating predictability in: (i) managerial skills, (ii) fund risk loadings, and (iii) benchmark returns. As in Avramov et al. (2007), we find that, before taking into account the effect of liquidity risk, long-only constrained hedge fund style portfolios that incorporate predictability in managerial skills generate superior performance.

However, the outperformance disappears or weakens dramatically for seven out of ten types of hedge fund style portfolios once the effect of liquidity risk is incorporated into the performance evaluation framework. Hence, for most hedge fund style-based portfolio strategies, "alphas" to a large extend reflect mere compensation for liquidity risk bearing. These results are robust to: (i) an alternative performance evaluation model (ii) an alternative liquidity risk proxy, (iii) the exclusion of the January effect on the liquidity premium and (iv) the exclusion of the recent financial crises data.

YORAM LANDSKRONER, Hebrew University of Jerusalem - Department of Finance and Banking
Email: msdinah@mscc.huji.ac.il
JACOB PAROUSH, Bar Ilan University - Department of Economics
Email: parousj@mail.biu.ac.il

Liquidity risk is one of the major risks faced by banks in addition to credit risk, market risk and operating risk. In this paper we construct a stylized model of bank management where the asset and liabilities liquidity structure are a key element in determining the bank's exposure to liquidity risk. The main results of our model are that liquidity risk increases when competition in the credit market increases while increasing competition in the deposit market will decrease the liquidity shortage. Our results are of particular importance as banks face increased liquidity risk due to there cent developments in the financial markets.

SOHNKE M. BARTRAM, Lancaster University
Email: s.m.bartram@lancaster.ac.uk
NATASHA BURNS, University of Texas, San Antonio
Email: natasha.burns@utsa.edu
JEAN HELWEGE, Penn State University
Email: juh20@psu.edu

Previous research on the impact of currency risk on stock returns has failed to find a significant role for foreign exchange rates. We address several possible explanations of this finding with a unique dataset of U.S. firms that acquire targets from other countries. Our dataset allows us to estimate the impact of exchange rates using bilateral exchange rates and a time period where underlying exposure is known to exist. We are able to determine if the change in exposure from before to after the acquisition is related to the acquiring firm's presence in the target country prior to the deal, which would indicate the acquisition serves as a natural hedge. We also investigate hedging behavior before and after the acquisition to determine if exposure estimation is hampered by the use of derivatives or debt denominated in foreign currencies. Estimates of exchange rate exposure are largely insignificant in our sample, although to a lesser extent than in some previous studies. While the time-series regressions reveal only a small fraction of significant exchange rate coefficients, the cross-sectional significance is much higher. We also find that identifying the appropriate bilateral exchange rate is critical in currency exposure tests. Among the firms in our sample with positive exposure prior to the acquisition, the average change in exposure as a result of the deal is negative. In contrast, firms with negative exposures prior to the deal have significantly more exposure after the deal. These marginal exposure estimates from after the deal is completed suggest that operational hedging is an important consideration with exchange rate exposures. We find that hedging with financial derivatives has little power to explain the exchange rate exposure puzzle.

STEPHEN J. BROWN, NYU Stern School of Business
Email: sbrown@stern.nyu.edu
WILLIAM N. GOETZMANN, Yale School of Management - International Center for Finance, National Bureau of Economic Research (NBER)
Email: WILLIAM.GOETZMANN@YALE.EDU
BING LIANG, University of Massachusetts at Amherst - Department of Finance & Operations Management
Email: bliang@som.umass.edu
CHRISTOPHER SCHWARZ, University of California at Irvine
Email: chris_schwarz@som.umass.edu

Over the last decade, several events, including the 2003 late-trading and market-timing mutual fund scandal, have demonstrated investment funds have significant levels of operational risk. While the BASEL II accord requires banks to quantify potential operational risk losses, investment fund regulators have instead required additional disclosure. Little research, however, has been performed evaluating the usefulness of regulatory disclosure in predicting and protecting investors from large operational risk events.

In this study, we will use a long time series of previously unexamined historical Form ADV filings to identify what disclosure information is useful to investors. By linking this data to mutual fund companies, we can examine what current conflicts of interest and regulatory issues predict future operational losses for investors. We will also use this information to form a univariate measure computed using standard mutual fund operating data that will inform investors about the mutual fund operational risk.

Ultimately, our research will have important implications for both investment fund investors and regulators. By determining what disclosure information is most useful, investors can focus on those variables to protect themselves from future problems, while regulators can improve the cost-benefit ratio of future disclosure requirements.

MARKUS LEIPPOLD, Imperial College London - Tanaka Business School
Email: leippold@gmail.com
FABIO TROJANI, University of St. Gallen - Department of Economics, University of Lugano
Email: fabio.trojani@unisg.ch

We introduce a new class of matrix-valued affine jump diffusions to model multivariate sources of risk within a single-asset or multi-asset framework. The flexibility and the tractability of our setting gives rise to an analytical transform analysis which opens up a wide range of applications within both single-asset and multi-asset models. Examples include multivariate option pricing with general volatility and correlation structures, fixed-income models with stochastically correlated risk factors and default intensities, or dynamic portfolio choice with jumps in returns, volatilities or correlations.

GREGORY A. KROHN, Bucknell University - Department of Economics
Email: krohn@bucknell.edu
WILLIAM R. GRUVER, Bucknell University - Department of Management
Email: gruver@bucknell.edu

Sparked by rising defaults on subprime mortgages, the financial turmoil of 2007 and 2008 threatened the stability of the worldwide financial system and led to unprecedented interventions in financial markets by central banks and other governmental institutions. This essay describes and explains the complexities of the financial turmoil of 2007 and 2008 for students of the financial system so that they might understand better how problems in the mortgage market led to the possibility of collapse of the financial system and the controversial actions taken by the Federal Reserve and other governmental entities. We draw several lessons about the behavior of financial markets and financial regulation from this historic episode.

THOMAS HARTMANN-WENDELS, University of Cologne - Department of Banking
Email: Hartmann-Wendels@wiso.uni-koeln.de
GEORG KEIENBURG, University of Cologne
Email: keienburg@wiso.uni-koeln.de

This article analyzes 373 venture capital transactions and seeks to determine why investment strategies differ across deals. In the absence of a frequent use of convertible securities, we find that straight equity, typical and atypical silent partnerships and mixes between these securities have been frequently used to finance entrepreneurial companies. Based on the chosen financial securities' upside potential and downside protection characteristics, we provide an explanation for the differing use of those securities. Our results indicate that entrepreneurial company characteristics, risk management and investor experience influence the selection of financial securities.