Volume 7, No. 3, Third Quarter 2009

Practitioner’s Digest • Vol. 7, No. 3

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.

Market Crises-Can the Physics of Phase Transitions and Symmetry Breaking Tell Us Anything Useful?

by: 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 fresh perspective on modeling and investment decision making.

Valuation of Credit Contingent Claims: An Arbitrage-Free Credit Model

by: Thomas S. Y. Ho and Sang Bin Lee

This study extends the generalized Ho-Lee model to the credit derivative swap (CDS) curve movements that ensures the hazard rate movement is arbitrage-free for any given CDS curve. This study shows that the generalized Ho-Lee model is not limited to pricing the interest contingent claims. The Ho-Lee model can be equally applicable to pricing the credit contingent claims. This model can value a broad range of credit contingent claims. These credit contingent claims include the American and the Bermudan CDS options, make-whole and callable bonds. This model features the separation of the specification of volatilities of the hazard rate from the fitting of the model to the CDS curve. Our model has several advantages over other models because of this separation feature. For example, we can use the model to depict the credit performance profile of a bond, by plotting the credit contingent claim values over a range of hazard curves. The performance profiles can identify the impact of the credit risks on the contingent claims.

Jumping the Gates: Using Beta-Overlay Strategies to Hedge Liquidity Constraints

by: 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 funds total assets. To reduce the investors risk exposures during these periods, we propose a futures overlay strategy designed to hedge out or control the common factor exposures of gated assets. By taking countervailing positions in stock, bond, currency, and commodity exposures, an investor can greatly reduce the systematic risks of their gated assets while still enjoying the benefits of manager-specific alpha. Such overlay strategies can also be used to reposition the betas of an investors entire portfolio, effectively rebalancing asset-class exposures without having to trade the less liquid underlying assets during periods of market dislocation. To illustrate the costs and benefits of such overlays, we simulate the impact of a simple beta-hedging strategy applied to long/short equity hedge funds in the TASS database.

The 4% Rule At What Price?

by: Jason S. Scott, William F. Sharpe and John G. Watson

The 4% rule is the advice many retirees follow for managing spending and investing. We examine this rules inefficiencies - the price paid for funding its unspent surpluses and the overpayments made to purchase its spending policy. We show that a typical rule allocates 10%-20% of a retirees initial wealth to surpluses and an additional 2%-4% to overpayments. Further, we argue that even if retirees were to recoup these costs, the 4% rules spending plan remains wasteful, since many retirees actually prefer a different, cheaper spending plan.

Which Explains an Equity Index’s Return Better, the Change in Its Own Implied Volatility or That for a Broader Index?

by: Susana Yu and Dean Leistikow

This paper examines the proper risk proxy for an equity index. For each of nine indexes, an implied volatility index (VI) is computed from its options. For each, it determines whether the indexes return is explained better by the contemporaneous change in its own VI or that for a broader index. Overall, the broader indexes VI explains the indexes contemporaneous return better. We also find that the difference between the broader indexes VI and the individual indexes VI contributes to explaining the indexes contemporaneous return. Finally, we determine that the forward return differential between the indexes returns associated with high and low VI quintiles ranked by both the indexes VI and the broader indexes VI is positive. We also find that the differential is higher when ranked by the broader indexes VI.

St. Xavior Parish Church

by: J. Peter Williamson

“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.

Managing Interest Rate Risk: The Next Challenge?

by: Sanjay K. Nawalkha and Gloria M. Soto

Are the managers of financial institutions ready for the small but increasingly significant risk of inflation in the near future, due to the unprecedented fiscal and monetary responses of the US government to prevent an economic collapse? This paper addresses this important issue by reviewing important findings in the area of interest rate risk management. We discuss five classes of models in the fixed income literature that deal with hedging the risk of large, nonparallel yield curve shifts. These models are given as (i) M-absolute/M-square models, (ii) duration vector/M-vector models, (iii) key rate duration models, (iv) principal component duration models, and (v) extensions of these models for fixed income derivatives, for valuing and hedging bonds, loans, demand deposits, and other fixed income instruments. These models can be used for designing various hedging strategies such as portfolio immunization, bond index replication, duration gap management, and contingent immunization, to protect against changes in the height, slope, and curvature of the yield curve. We argue that the current regulatory models proposed by the US Federal Reserve, the Office of Thrift Supervision, and the Bank of International Settlements may understate the true interest rate risk exposure of financial institutions, if sharp increases in interest rates lead to higher default risk and quickening of the pace of deposit withdrawals.