How to Price Hedge Funds: From Two- to Four-Moment CAPM

Abstract

The CAPM model is hard put to explain the superior performance of hedge funds in the past. We argue that the Markowitz mean-variance criterion underpinning the traditional CAPM may fail to capture systematic features characterizing hedge fund performance. Thus, we extend the two-moment market model to a higher-moment model to accommodate coskewness and cokurtosis. The higher-moment approach is more appropriate for capturing the non-linear relation between hedge fund and market returns and accounting for the specific risk-return payoffs of each hedge fund investment strategy. The key result is that the use solely of the two-moment pricing model may be misleading and may wrongly indicate insufficient compensation for the investment risk.

Keywords: Hedge funds, CAPM, higher moments, skewness, kurtosis, required rate of return

JEL Classification: G12