Volume 7, No. 2, Second Quarter 2009

Practitioner’s Digest • Vol. 7, No. 2

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.

Liquidity Risk and Limited Arbitrage: Are Taxpayers Helping Hedge Funds Get Rich?

by: Evan Gatev

Hedge funds facing capital constraints during market-wide liquidity shocks use bank credit lines to reduce the limits to arbitrage. During shocks, government-protected bank deposits receive inflows and this exclusive low cost funding enables banks to lend to hedge funds. In effect, banks compete away the government subsidy while tax-avoiding hedge funds reap the lion share of the benefits. After the advent of hedge funds, the existing government safety net protecting banks is no longer optimal in the sense of maximizing social surplus.

A Structural Analysis of the Default Swap Market – Part II (Relative Value)

by: Lisa Goldberg, Rajnish Kamat and Jason Kremer

We evaluate several long/short strategies for managing a portfolio of default swaps. The strategies are based on a ranking of credits by residuals, which are the differences between market spreads and spreads generated by the iSpread structural model. Investment grade portfolios for the United States and Europe earned an average of 70 basis points for each long dollar notional between January 2004 and December 2006. Noninvestment grade portfolios earned 321 basis points averaged over the same regions and time period. Transaction cost estimates based on scenario analysis ranged from 19 to 27 basis points for investment grade and 26 to 54 basis points for noninvestment grade portfolios. Strategies that aim to mitigate transaction cost by holding trades with little profit showed mixed results.

A Simple Model for Time-Varying Expected Returns on the S&P 500 Index

by: James S. Doran, Ehud I. Ronn and Robert S. Goldberg

This paper presents a parsimonious, implementable model for the estimation of the short and long-term expected rates of return on the S&P 500 stock market Index. Sufficient statistics for the expected return on the S&P 500 Index consist of the risk-free rate of interest, the option market's (priced) implied volatility on the S&P 500 Index, and a measure of the economy's wealth level.

The short- and long-term risk-free rates of interest reflect the impact of the level and slope of the risk-free term structure. The implied volatility captures a forward-looking measure of uncertainty. Utility-function assumed decreasing relative risk aversion gives rise to an increased willingness to invest in risky assets when current wealth level is "high". The model's empirical parameters are estimated using Livingston/Philadelphia Fed growth rates substituted into a dividend-discount model.

The Value Spread as a Market Timing Signal: Evidence from Asia

by: Charles E. Hyde and Michael P. Triguboff

Using monthly data from 1992-2006, we show the value premium in Asia ex Japan is positively related to the cross-sectional dispersion of four common value ratios. The book-to-price and cash flow-to-price spreads exhibit the strongest relationship. Typical month-to-month variation in these two value spreads is often associated with a 0.4-1.0% per annum change in the value premium. Short-side positions are typically solely responsible for the positive relationship, particularly in recent years. Our results provide out of sample support for previous findings for the US market, but cast doubt on whether mean reversion alone can explain the observed value premium-spread relationship.

Dealing With Dimension: Option Pricing on Factor Trees

by: Sanjiv R. Das and Brian Granger

We present a scheme for pricing derivatives on M assets on K -factor recombining trees with N periods. The computational complexity of these trees is O(NK +1), i.e. polynomial in N, making it possible to price a wide range of derivatives without resorting to Monte Carlo simulation. Numerical implementation examples are provided, along with a discussion of the issues that arise when these models are implemented on multicore processors. A calibration example is provided that shows how individual assets may be embedded on a multi-factor tree.

The Liquidation of Amaranth

by: George Chacko and Scott Thomas

“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.

Enough. True Measures of Money, Business and Life

by: John C. Bogle • 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.