Volume 6, No. 4, Fourth Quarter 2008

Risk and Return in Behavioral SDF-Based Asset Pricing Models

by: 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 pricing kernel-based methodology favored by neoclassical asset pricing theorists. Methodologically, change of measure techniques are used to provide a formal definition of sentiment and to capture the impact of behavioral beliefs and preferences on asset prices. Introducing behavioral assumptions into a pricing kernel framework provides insights into the impact of psychological features on the relationship between risk and return, mean-variance portfolios, the role of coskewness, and the pricing of derivatives. A behavioral theory for the pricing of derivatives is particularly germane to understanding the major turmoil in global financial markets which took place in 2008. That turmoil, which reflected highly volatile swings of sentiment in the markets for both equity and debt, stemmed from significant sentiment in the market for mortgages and derivatives based on mortgages.

Hedge Fund Due Diligence: A Source Of Alpha In A Hedge Fund Portfolio Strategy

by: 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 diversified hedge fund portfolio can be enhanced by excluding those funds likely to do poorly or fail due to operational risk concerns. However, effective due diligence is an expensive concern. This implies that there is a strong competitive advantage to those funds of funds sufficiently large to absorb this fixed and necessary cost. The consequent economies of scale that we document in funds of funds are quite substantial and support the proposition that due diligence is a source of alpha in hedge fund investment.

Measuring the Risk of Large Losses

by: Kay Giesecke, Thorsten Schmidt and Stefan Weber

Risk management is an important component of the investment process. It requires quantitative measures of risk that provide a metric for the comparison of financial positions. In this expository note we give an overview of risk measures. In particular, we contrast different risk measures with respect to their sensitivity to potentially large losses due to market wide shocks. The industry standard value at risk exhibits many deficiencies. It does not account for the size of the losses and may penalize diversification. We compare value at risk to alternative risk measures including average value at risk and the less well know but superior utility-based shortfall risk.

Consolidated Lunch Pail

by: Jack L. Treynor

“Case Studies” presents a case pertinent to contemporary issues and events in investment management. Insightful and provocative questions are posed at the end of each case to challenge the reader. Each case is an invitation to the critical thinking and pragmatic problem solving that are so fundamental to the practice of investment management.

Behavioral Investing: A Practitioners Guide to Applying Behavioral Finance

by: James Montier • reviewed by: Bruce Grantier

“Book Reviews” identifies important, and often popular, new books from a wide range of investment topics. Beyond providing a summary and review of the content and style of the books, “Book Reviews” seeks to contribute to a conscious, critical, and informed approach to investment literature.

Practitioner’s Digest • Vol. 6, No. 4

The “Practitioners Digest” emphasizes the practical significance of manuscripts featured in the “Insights” and “Articles” sections of the journal. Readers who are interested in extracting the practical value of an article, or who are simply looking for a summary, may look to this section.