Vineer Bhansali This paper addresses aspects of the current financial market crisis by drawing analogies from the physics of phase transitions. If such an analogy is indeed appropriate, then the evolving dynamics of financial markets might have characteristics that the traditional models of finance will not be able to handle, requiring the need for a… Read more
Articles
JUMPING THE GATES: USING BETA-OVERLAY STRATEGIES TO HEDGE LIQUIDITY CONSTRAINTS
Alexander D. Healy and Andrew W. Lo In response to the current financial crisis, a number of hedge funds have implemented “gates” on their funds that restrict withdrawals when the sum of redemption requests exceeds a certain percentage of the fund’s total assets. To reduce the investor’s risk exposures during these periods, we propose a… Read more
THE DYNAMICS OF LEVERAGED AND INVERSE EXCHANGE-TRADED FUNDS
Minder Cheng and Ananth Madhavan Leveraged and inverse Exchange-Traded Funds (ETFs) have attracted significant assets lately. Unlike traditional ETFs, these funds have “leverage” explicitly embedded as part of their product design. While these funds are primarily used by short-term traders, they are gaining popularity with individual investors placing leveraged bets or hedging their portfolios. The… Read more
HUMPBACKS IN CREDIT SPREADS
Deepak Agrawal and Jeffrey R. Bohn Models of credit valuation generally predict a hump-shaped spread term structure for low quality issuers. This is understood to be driven by the shape of the underlying conditional default probabilities curve. We show that (a) recovery assumptions and (b) deviation of a bond’s price from its par value can… Read more
A STRUCTURAL ANALYSIS OF THE DEFAULT SWAP MARKET—PART 1 (CALIBRATION)
Lisa R. Goldberg, Rajnish Kamat and Vijay Poduri We analyze the default swap market with the two factor I 2 structural model, which is driven by firm value and firm leverage. This paper describes a cross-market model calibration process that results in close alignment of our model spreads with the market. This enables us to… Read more
WHERE DO ALPHAS COME FROM?: A MEASURE OF THE VALUE OF ACTIVE INVESTMENT MANAGEMENT
Andrew W. Lo The value of active investment management is traditionally measured by alpha, beta, volatility, tracking error, and the Sharpe and information ratios. These are essentially static characteristics of the marginal distributions of returns at a single point in time, and do not incorporate dynamic aspects of a manager’s investment process. In this paper… Read more
THE STRUCTURE OF HYBRID FACTOR MODELS
Jose Menchero and Indrajit Mitra We study the problem of augmenting fundamental risk models with statistical factors in order to capture the risk associated with omitted factors. The statistical factors are estimated by applying principal component analysis to the cross-sectional residuals. We show that in the limit of zero noise, the statistical factors can be… Read more
OPTIMAL TRADING STRATEGY WITH OPTIMAL HORIZON
Edward E. Qian Portfolio implementation is an essential part of active investment strategies. The trading horizon—the length of time allocated for trade implementation, is an important consideration in portfolio trading. Previous research on optimal trading limits the trading horizon as a fixed value. In this paper, we treat it as an endogenous factor and find… Read more
RISK AND RETURN IN BEHAVIORAL SDF-BASED ASSET PRICING MODELS
Hersh Shefrin Behavioral finance has profound implications for the pricing of all assets, from standard fixed income securities and equity to complex derivatives. This paper describes a general, unified framework for analyzing the impact of sentiment on asset prices. The approach brings together the psychological assumptions favored by behavioral asset pricing theorists and the powerful… Read more
HEDGE FUND DUE DILIGENCE: A SOURCE OF ALPHA IN A HEDGE FUND PORTFOLIO STRATEGY
Stephen J. Brown, Thomas L. Fraser and Bing Liang Due diligence is an important source of alpha in a well designed hedge fund portfolio strategy. It is generally understood that the high returns possible in investing in hedge funds are somewhat offset by the relative lack of transparency on operational issues. The performance of a… Read more