Volume 9, No. 3, Third Quarter 2011

What Interest Rate Models To Use? Buy Side Versus Sell Side

by: Sanjay K. Nawalkha and Riccardo Rebonato

Does the selection of a specific interest rate model to use for pricing, hedging, and risk return analysis depend upon whether the user is a buy-side institution or a sell-side dealer bank? Sanjay Nawalkha and Riccardo Rebonato debate this question in this paper and provide some insightful conclusions. Responding to Nawalkha's [2010] critique of the LMM-SABR model, Rebonato argues that the LMM-SABR model is currently the best available model for the sell-side dealer banks for pricing and hedging large portfolios of complex interest rate derivatives within tight time constraints. Nawalkha in his rejoinder argues that the LMM-SABR model is useless at best, and dangerous at worst for the buy-side institutions, and these institutions must use time-homogeneous fundamental and single-plus interest rate models (e.g., such as affine and quadratic term structure models) for risk-return analysis under the physical measure, as this cannot be done using the time-inhomogeneous double-plus and triple-plus versions of the LMM-SABR model.

The Performance, Pervasiveness, and Determinants of Value Premium in Different US Exchanges: 1985-2006

by: George Athanassakos

Using AMEX, NASDAQ and NYSE stock market data for the period 1985-2006, this paper sheds further light into the value premium and the discussion of whether the value premium is driven by risk or behavioral factors. The paper utilizes a more comprehensive set of data and tests than previous studies and a research methodology that minimizes potential data snooping problems and confounding inferences. We document a consistently strong value premium in all markets examined, which persists in both bull and bear markets, as well as in recessions and recoveries. We show that the value premium is not driven by a few outliers, but it is pervasive as the overwhelming majority of stocks in the value portfolio have positive returns, and the majority of the industries in our sample have positive value premiums. The value premium, in general, remains positive and statistically significant over time. Our results are consistent with, but, in general, stronger than, those of other US studies. Previous studies' results seem to be driven primarily by AMEX and NYSE stocks, as NASDAQ stocks experience much stronger value premium than other markets. In terms of explaining the drivers of the value premium, having looked at this question from many angles, we conclude that the evidence is mixed. It seems that both risk and mispricing may play a role in explaining the value premium, although the scale of the evidence seems to tilt more to the side of mispricing. The paper's conclusions both with regards to the value premium and its drivers hold up well to various robustness tests.

Portfolio Diversification

by: James A. Bennett and Richard W. Sias

Contrary to conventional wisdom, there is no evidence investors can, or have ever been able to, easily form portfolios containing negligible exposure to unsystematic returns. Because well-diversified portfolios are the bedrock upon which so much financial theory is built, investors' inability to easily form well-diversified portfolios helps explain the persistence of anomalies and the possibility of "bubbles" in asset prices.

Hedge Funds: A Sensible Approach to Oversight

by: Antony E. Ghee

After years of debating whether additional regulation should be imposed on hedge funds, legislative initiatives, such as the Dodd-Frank Act, have recently been enacted and could significantly alter the scope of government oversight in an industry that has, until recently, been subject to little regulatory scrutiny. The purpose of this article is not to critique recent legislative initiatives, but rather discuss the historical failings of regulators to detect fraud and other misconduct at early stages. In doing so, this article will also focus on recurring themes that are prevalent in fraud related misconduct, and offer suggestions upon which regulators may improve their efforts to detect fraud before investors suffer significant losses. In 2003, the SEC estimated that as many as 7,000 hedge funds operated in the United States managing approximately $600 to $650 billion in assets. More recent estimates suggest that industry assets peaked around $3.0 trillion just before the credit crisis and global recession began. These figures underscore the point that the industry has experienced a period of exponential growth and simultaneously heightened the concerns of regulators. However, it should be noted that SEC enforcement actions were brought against less than 1% of hedge funds during the past decade. Accordingly, while there has, at times, been investment advisers that engaged in unethical behavior, most hedge fund managers appear to operate with integrity. Thus, the proposals outlined herein are intended to alter the behavior of the unethical while minimizing the impact to industry practitioners that operate with integrity.

Fat Tails and Stop-Losses in Portable Alpha

by: Mark B. Wise, Yonathan Schwarzkopf and Vineer Bhansali

We investigate the optimal stop-loss on the alpha investment for a portable alpha vehicle. The optimal stop-loss maximizes investors utility of wealth for a portfolio consisting of a portable alpha fund and risk free assets. We model the dynamics of the assets as a combination of a normal era with positive average returns and stressed era with negative average returns. We discuss the dependence of the optimal choice of stop-loss on the probability of being in the stressed era, the average return of the alpha asset in the stressed era and on the cost to liquidate the risky alpha asset.

The Nutty Professor (36)

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.

Bond Portfolio Investing and Risk Management

by: Vineer Bhansali • reviewed by: Sebastien Page

“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. 9, 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.