Centre for Hedge Fund Research Reports

Research in the Centre for Hedge Fund Research is continuing, with projects underway on the analysis of predictability in hedge fund returns; correlation risk exposure and hedge fund performance; intraday patterns in FX rates; dynamic portfolio construction; and the pricing of basket options.

Working Papers

Paper 08
Investing in Hedge Funds when the Fund's Characteristics are Exploitable
Juha Joenväärä (University of Oulu), Hannu Kahra (University of Oulu)

In this paper we form hedge fund investment strategies that exploit optimally fund characteristics using the Brandt, Santa-Clara, and Valkanov (2009) approach. We exploit economically well motived fund characteristics based on managerial incentives, share restrictions, and the fund size. The optimal portfolio weight of a specific hedge fund can be seen as a ranking between funds. The results suggest that small funds with high managerial incentives and long notice periods obtain the highest rankings. Our findings suggest that the proposed characteristics-based strategy delivers significant outperformance for a real-time investor. The results are robust across a wide range of performance measures even after controlling for underlying redemption and subscription impediments associated with investment decisions.

Paper 07
Locked Up by a Lockup: Valuing Liquidity as a Real Option
Andrew Ang, Nicolas P.B. Bollen

Hedge funds often impose lockups and notice periods to limit the ability of investors to withdraw capital. We model the investor's decision to withdraw capital as a real option and treat lockups and notice periods as exercise restrictions. Our methodology incorporates time-varying probabilities of hedge fund failure and optimal early exercise. We estimate a two-year lockup with a three-month notice period costs approximately 1% of the initial investment for an investor with CRRA utility and risk aversion of 3. The cost of illiquidity can easily exceed 10% if the hedge fund manager suspends withdrawals.

Paper 06
The Fragile Capital Structure of Hedge Funds and the Limits to Arbitrage
Xuewen Liu (Imperial College Business School), Antonio S. Mello (Imperial College Business School)

During a  financial crisis, when markets most need liquidity and arbitrage trading to correct prices, hedge funds reduce their exposures and positions. The paper explains this phenomenon in light of coordination risk. We argue that the fragile nature of the capital structure of hedge funds, combined with low market liquidity, introduces coordination risk to hedge fund's investors. Coordination risk effectively limits hedge funds' arbitrage capabilities. We present a model of hedge funds' optimal asset allocation with coordination risk. We show that hedge fund managers behave conservatively and even give up participating in the market when they factor coordination risk into their investment decisions. The model gives a new explanation to the limits to arbitrage. We also discuss other implications of the model.

Paper 05
Equilibrium Index and Single-Stock Volatility Risk Premia
Andrea Buraschi (Imperial College London), Fabio Trojani (University of Lugano), Andrea Vedolin (University of Lugano)

Writers of index options earn high returns due to a significant and high volatility risk premium, but writers of options in single-stock markets earn lower returns. Using an incomplete information economy, we develop a structural model with multiple assets where agents have heterogeneous beliefs about the growth of firms' fundamentals and a business-cycle indicator and explain the different volatility risk premia of index and single-stock options. The wedge between the index and individual volatility risk premium is mainly driven by a correlation risk premium which emerges endogenously due to the following model features: In a full information economy with independent fundamentals, returns correlate solely due to the correlation of the individual stock with the aggregate endowment ("diversification effect"). In our economy, stock return correlation is endogenously driven by idiosyncratic and systemic (business-cycle) disagreement ("risk-sharing effect"). We show that this effect dominates the diversification effect, moreover it is independent of the number of firms and a firm's share in the aggregate market. In equilibrium, the skewness of the individual stocks and the index differ due to a correlation risk premium. Depending on the share of the firm in the aggregate market, and the size of the disagreement about the business cycle, the skewness of the index can be larger (in absolute values) or smaller than the one of individual stocks. As a consequence, the volatility risk premium of the index is larger or smaller than the individual. In equilibrium, this different exposure to disagreement risk is compensated in the cross-section of options and model-implied trading strategies exploiting differences in disagreement earn substantial excess returns. We test the model predictions in a set of panel regressions, by merging three datasets of f irm-specific information on analysts' earning forecasts, options data on S&P 100 index options,options on all constituents, and stock returns. Sorting stocks based on differences in beliefs, we find that volatility trading strategies exploiting different exposures to disagreement risk in the cross-section of options earn high Sharpe ratios. The results are robust to different standard control variables and transaction costs and are not subsumed by other theories explaining the volatility risk premia.

Paper 04
Differences in Beliefs and Currency Risk Premia
Alessandro Beber (Amsterdam Business School), Francis Breedon (Imperial College London), Andrea Buraschi (Imperial College London)

This paper investigates how heterogeneous beliefs of professional investors impact on the currency
options market. Using a un ique data set with detailed information on the foreign-exchange forecasts
of about 50 market participants over more than ten years, we construct an empirical proxy for dif-
ferences in beliefs. We show that our proxy has a statistically and economically strong effect on the
implied volatility of currency options beyond the volatility of current macroeconomic fundamentals.
We document that di¤erences in beliefs impact also on the shape of the implied volatility smile,
on the volatility risk-premia, and on future currency returns. Our evidence demonstrates that a
process related to the uncertainty about fundamentals has important asset pricing implications,
even in the absence of short-selling constraints.

Paper 03
Model Averaging in Risk Management with an Application to Futures Markets
M. Ha shem Pesaran (University of Cambridge, CIMF, GSA Capital and USC), Christoph Schleicher (GSA Capital), Paolo Zaffaroni (Imperial College London and CIMF)

This paper considers the problem of model uncertainty in the case of multi-asset volatility models and discusses the use of model averaging techniques as a way of dealing with the risk of inadvertently using false models in portfolio management. Evaluation of volatility models is then considered and a simple Value-at-Risk (VaR) diagnostic test is proposed for individual as well as `average' models. The asymptotic as well as the exact finite-sample distribution of the test statistic, dealing with the possibility of parameter uncertainty, are established. The model averaging idea and the VaR diagnostic tests are illustrated by an application to portfolios of daily returns on six currencies, four equity indices, four ten year government bonds and four commodities over the period 1991-2007. The empirical evidence supports the use of `thick' model averaging strategies over single models or Bayesian type model averaging procedures.

Paper 02
Dynamic Portfolio Optimisation when Investors Have CRRA Preferences
James Sefton (Imperial College Business School)

Given investors risk-return preferences can be represented using a standard utility function (CRRA), the problem of maximizing the total return to a portfolio with regular rebalancing over a given horizon can be rewritten as an optimal risk-sensitive (or H8) control problem.

F urther if the dynamic evolution of the forecasts to th e equity assets can be written as linear stochastic system – which can encompass a simple representation of trading transaction costs as in Engle, Ferstenberg (2007) and Almgren, Chriss (2000) – then the dynamic optimal portfolio can be written in terms of the solution to a matrix Riccati equation.

This optimal dynamic portfolio can be rewritten as the optimal static mean-variance portfolio plus a weighted sum of Merton (1973) hedging portfolios. This solution procedure is applied to both the forecast horizon problem described above and to the finite-horizon dynamic asset allocation problem discussed in Campbell and Viceira (2003).

Paper 01
Hedge Funds, Managerial Skill, and Macroeconomic Variables
(previously circulated under the title "Investing in Hedge Funds When Returns are Predictable")
Doron Avramov (R.H. Smith School of Business, University of Maryland), Robert Kosowski (Imperial College Business School), Narayan Y. Naik (London Business School), Melvyn Teo (Singapore Management University)

This paper evaluates hedge fund performance through portfolio strategies that incorporate predictability based on macroeconomic variables. Incorporating predictability substantially improves out-of-sample performance for the entire universe of hedge funds as well as for various investment styles. While we also allow for predictability in fund risk loadings and benchmark returns, the major source of investment profitability is predictability in managerial skills. In particular, long-only strategies that incorporate predictability in managerial skills outperform their Fung and Hsieh (2004) benchmarks by over 17 percent per year. The economic value of predictability obtains for different rebalancing horizons and alternative benchmark models. It is also robust to adjustments for backfill bias, incubation bias, illiquidity, fund termination, and style composition.