Volume 7, No. 4, Fourth Quarter 2009

Practitioner’s Digest • Vol. 7, 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.

The 7 Habits of Highly Suspicious Hedge Funds

by: Richard Bookstaber

“Insights” features the thoughts and views of the top authorities from academia and the profession. This section offers unique perspectives from the leading minds in investment management.

The Risk That Risk Will Change

by: Robert F. Engle

Standard approaches to risk management focus on short run risks, yet many positions are held for longer periods. Over such holding periods there is a risk that risks will change. In this note several easily implemented approaches to estimating the term structure of risk are proposed based on either statistical or economic criteria. It is argued that some portion of the financial crisis of 2007-2008 was due to the use of short run risk measures to assess long term risks.

The Dynamics of Leveraged and Inverse Exchange-Traded Funds

by: 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 structure of these funds, however, creates both intended and unintended characteristics that are not seen in traditional ETFs. This note provides a unified framework to better understand the underlying dynamics of leveraged and inverse ETFs, their impact on market volatility and liquidity, unusual features of their product design, and questions of investor suitability. We show that the daily re-leveraging of these funds can exacerbate volatility towards the close. We also show that the gross return of a leveraged or inverse ETF has an embedded path-dependent option that under certain conditions can lead to value destruction for a buy-and-hold investor. The unsuitability of these products for longer-term investors is reinforced by the drag on returns from high transaction costs and tax inefficiency.

Striking Regulatory Irons While Hot

by: Hersh Shefrin and Meir Statman

We are in the midst of what might end up as the most significant change to financial regulations since the Great Depression. This is because the financial and economic crisis that continues to engulf us is the most severe crisis since the Great Depression. The markets for houses, mortgages, and derivatives linked to them have played critical roles in the crisis, and debates about the shape of future financial regulation have led to intense focus on these markets. In this paper we place the current debate about regulatory changes within a larger frame. We present a framework based on capture theory and fairness where regulatory irons are heated by changes in financial markets such as a plunge from exuberant booms to frightening crashes, changes in the economy such as a fall from heady job creation to dispiriting unemployment, changes in technology such as an innovation in information technology which enables banks to substitute the Internet for tellers, changes in politics, such as one party displacing another, or new rulings by the Supreme Court, such as the one that opened the door to interstate banking. We discuss the fires that heat regulatory irons, the craftsmen standing ready to strike them, and the process by which they are struck, in credit card and bank regulations, insider trading regulations, Regulation FD, trading halts, the Global Settlement, and the Sarbanes-Oxley Act. We conclude with our prescriptions.

Case Studies

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.

Financial Applications with Parallel R

by: Sanjiv R. Das and Brian Granger

The use of statistical packages in finance has two functions. One, econometric analysis of large volumes of data, and two, programming financial models. A popular package for these purposes is R. In this article we will examine two canonical applications of parallel programming for option pricing. We use the ParallelR package developed by REvolution Computing. We price options using trees and Monte Carlo simulation. Both these approaches are commonly used for option pricing and are amenable to parallelization and grid computing. In this paper we demonstrate the application using the widely used mathematical/statistical R package.

The Ascent of Money: A Financial History of the World

by: Niall Ferguson • 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.