Abstracts
Hedge Fund Performance 1990-2000: Do the “Money Machines” Really Add Value?
Gaurav S. Amin and Harry M. Kat
We investigate the claim that hedge funds offer investors a superior
risk-return tradeoff. We do so using a continuous-time version of Dybvig's
(1988a), (1988b) payoff distribution pricing model. The evaluation model,
which does not require any assumptions with regard to the return
distribution of the funds to be evaluated, is applied to the monthly
returns of 77 hedge funds and 13 hedge fund indices from May 1990-April
2000. The results show that, as a stand-alone investment, hedge funds do
not offer a superior risk-return profile. We find 12 indices and 72
individual funds to be inefficient, with the average efficiency loss
amounting to 2.76% per annum for indices and 6.42% for individual funds.
Part of the inefficiency cost of individual funds can be diversified away.
Funds of funds, however, are not the preferred vehicle for this as their
performance appears to suffer badly from their double fee structure.
Looking at hedge funds in a portfolio context results in a marked
improvement in the evaluation outcomes. Seven of the 12 hedge fund indices
and 58 of the 72 individual funds classified as inefficient on a
stand-alone basis are capable of producing an efficient payoff profile
when mixed with the S&P 500. The best results are obtained when 10%-20% of
the portfolio value is invested in hedge funds.
The Valuation of Default-Triggered Credit Derivatives
Ren-Raw Chen and Ben J. Sopranzetti
Credit derivatives are among the fastest growing contracts in the
derivatives market. We present a simple, easily implementable model to
study the pricing and hedging of two widely traded default-triggered
claims: default swaps and default baskets. In particular, we demonstrate
how default correlation (the correlation between two default processes)
impacts the prices of these claims. When we extend our model to
continuous time, we find that, once default correlation has been taken
into consideration, the spread dynamics have very little explanatory
power.
Pricing Treasury Inflation Protected Securities and Related Derivatives using an HJM Model
Robert Jarrow and Yildiray Yildirim
This paper uses an HJM model to price TIPS and related derivative
securities. First, using the market prices of TIPS and ordinary U.S.
Treasury securities, both the real and nominal zero-coupon bond price
curves are obtained using standard coupon bond price stripping procedures.
Next, a three-factor arbitrage-free term structure model is fit to the
time-series evolutions of the CPI-U and the real and nominal zero-coupon
bond price curves. Then, using these estimated term structure parameters,
the validity of the HJM model for pricing TIPS is confirmed via its
hedging performance. Lastly, the usefulness of the pricing model is
illustrated by valuing call options on the inflation index.
A Multifactor Explanation of Post-Earnings Announcement Drift
Dongcheol Kim and Myungsun Kim
To explain post-earnings announcement drift, we construct a risk factor related to unexpected earnings surprise, and propose a four-factor model by adding this risk factor to Fama and French's (1993), (1995) three-factor model. This earnings surprise risk factor provides a remarkable improvement in explaining post-earnings announcement drift when included in addition to the three factors of Fama and French. After adjusting raw returns for the four risk factors, the cumulative abnormal returns over the 60 trading days subsequent to quarterly earnings announcements are economically and statistically insignificant. Furthermore, except for the first two days after the earnings announcement, the cumulative abnormal returns and the arbitrage returns from our four-factor model are relatively stable over the testing period and never significant on any day of the testing period. On the other hand, the arbitrage returns from the other models increase over the 60-day testing period. We argue that most of the post-earnings announcement drift observed in prior studies may be a result of using misspecified models and failing to appropriately adjust raw returns for risk.
Interaction of Debt Agency Problems and Optimal Capital Structure: Theory and Evidence
Connie X. Mao
Does more leverage always worsen the debt agency problem? This paper
presents a unified analysis that accounts for both risk-shifting and
under-investment debt agency problems. For firms with positive marginal
volatility of investment (defined as the change in cash flow volatility
corresponding to a change of investment scale), equity holders'
risk-shifting incentive will mitigate the under-investment problem. This
implies that, contrary to conventional views, the total agency cost of
debt does not uniformly increase with leverage. This model further
predicts that, for high growth firms in which the under-investment problem
is severe, the optimal debt ratio is positively related to the marginal
volatility of investment. Empirical results support this prediction.
Do Persistent Large Cash Reserves Hinder Performance?
Wayne H. Mikkelson and M. Megan Partch
Conservative financial policies are often criticized as serving the
interests of managers rather than the interests of stockholders. We test
this argument by examining the operating performance and other
characteristics of firms that for a five-year period held more than
one-fourth of their assets in cash and cash equivalents. Following the
five-year period, operating performance of high cash firms is comparable
to or greater than the performance of firms matched by size and industry
or by a measure of proclivity to hold substantial cash. In addition,
proxies for managerial incentive problems, such as ownership and board
characteristics, are not unusual and do not explain differences in
operating performance among high cash firms. We find that high cash
holdings are accompanied by greater investment, particularly R&D
expenditures, and by greater growth in assets. For firms that
persistently hold large cash reserves, we conclude that such policies
support investment without hindering corporate performance.
Pricing Bounds on Asian Options
J. Aase Nielsen and Klaus Sandmann
This paper aims to develop and compare bounds on the pricing formulas for
European type discrete Asian options. The lower bound is found by
conditioning the maturity payment of the Asian option by the geometric
average and the bound derived can be expressed as a portfolio of delayed
payment European call options. Several exercise price-dependent upper
bounds are derived. Like the lower bound, one of the upper bounds is
expressed as a portfolio of delayed payment European call options. Through
a numerical analysis, we conclude that more information is gained from the
readily calculated bounds than from the usually applied pricing
approximations. From the closed-form solutions of the bounds, hedging
positions are finally derived.
Do Momentum-Based Strategies Still Work in Foreign Currency Markets?
John Okunev and Derek White
This paper examines the performance of momentum trading strategies in
foreign exchange markets. We find the well-documented profitability of
momentum strategies during the 1970s and the 1980s has continued
throughout the 1990s. Our approach and findings are insensitive to the
specification of the trading rule and the base currency for analysis.
Finally, we show that the performance is not due to a time-varying risk
premium but rather depends on the underlying autocorrelation structure of
the currency returns. In sum, the results lend further support to prior
momentum studies on equities. The profitability to momentum-based
strategies holds for currencies as well.
Risk Premia and the Dynamic Covariance between Stock and Bond Returns
John T. Scruggs and Paskalis Glabadanidis
We investigate whether intertemporal variation in stock and bond risk
premia can be explained by time-varying covariances with priced risk
factors. We estimate and test a conditional two-factor variant of Merton's
ICAPM in which excess returns on an equity index and a long-term
government bond portfolio proxy for risk factors. Conditional second
moments follow the asymmetric dynamic covariance (ADC) model of Kroner and
Ng (1998). We find that conditional bond variance responds symmetrically
to bond return shocks but is virtually unaffected by stock return shocks,
while conditional stock variance responds asymmetrically to both stock and
bond return shocks. Models that impose a constant correlation restriction
on the covariance matrix between stock and bond returns are strongly
rejected. We conclude that the conditional two-factor model fails to
adequately explain intertemporal variation in stock and bond risk
premia.
Does Coordinated Institutional Investor Activism Reverse the Fortunes of Underperforming Firms?
Wei-Ling Song and Samuel H. Szewczyk
We investigate the impact of Focus Listing by the Council of Institutional
Investors on targeting poorly performing firms. Post-listing stock
returns for the targeted firms differ insignificantly from those of a
suitable benchmark group. Institutional investors increase their holdings
of targeted firms, but not by more than those of the benchmark firms.
Similarly, though analysts revise earnings forecasts up for Focus Listed
firms, they do so well after the listing event and positive revisions are
no greater than the benchmark group. Moreover, there appears to be little
difference between Focus List and benchmark firms in the incidence of
post-listing events such as mergers and stock repurchases. Overall, we
find very little evidence of the efficacy of shareholder activism.