EDHEC Publications
A Predictive System with Heteroscedastic Expected Returns and Economic Constraints
2014
We propose a variation of a predictive system that incorporates two (additional) economically motivated assumptions about the dynamics of expected returns, namely 1) their positivity, and 2) a time-varying volatility correlated with economic regimes. The implications of the modified system are consistent with well established empirical facts of stock returns, in particular, the simpler version of the modified system without predictors can explain the well documented countercyclicality of the dividend-price ratio’s predictive power.
Catastrophe Bonds: An Important New Financial Instrument
2014
This paper describes key features of catastrophe bonds or CAT bonds. CAT bonds are issued by a reinsurer for indemnification against tail risks of a major disaster such as a hurricane, earthquake, or pandemic. The money with which investors purchase CAT bonds is deposited in safe securities such as US Treasuries. The investor then receives interest on these securities plus premiums paid regularly by the issuer of the bond. If a “triggering event” (the covered catastrophe) occurs before maturity the bond may “default” in that investors may not be returned part or all of their principal, which...
Equal or Value Weighting? Implications for Asset-Pricing Tests
2014
Does the choice of weighting scheme used to form test portfolios influence inferences drawn from empirical tests of asset pricing? To answer this question we first show that, with monthly rebalancing, an equal-weighted portfolio outperforms a value-weighted portfolio in terms of total mean return, four-factor alpha, and Sharpe ratio. We then explain that this outperformance is partly because the equal-weighted portfolio has higher exposure to systematic risk factors; but, a considerable part (42%) of the outperformance comes from the difference in alphas, which is a consequence of the...
Global Style Portfolios Based on Country Indices
2014
Factor portfolios created by dynamically weighting country indices generated significant global market adjusted returns over the last 30 years. The comparison between stock and country based factor portfolios suggests that country based value, size and momentum factor portfolios implemented through index futures or country ETFs capture a large part of the return of stock based factor strategies. Given the complex issues and costs involved in implementing stock based factor strategies in practice, country based factor strategies offer a viable alternative.
Benchmarking Long-Term Investment in Infrastructure: Objectives, Roadmap and Recent Progress
2014
This paper proposes an approach to benchmark long-term investments in infrastructure, where long-term investment simply refers to any unlisted and illiquid asset. It first highlights the reasons why benchmarking long-term infrastructure investments has become a sine qua non to match the supply and demand of long-term capital, improve asset allocation outcomes for investors and support the development of the economy.
A Proposal for an Interest Rate Dampener for Solvency II to Manage Pro-Cyclical Effects and Improve Asset-Liability Management
2014
The aim of this study is to propose the introduction of a Dampener adjustment in the risk measure for bond instruments — which takes economic cycles into account. Firstly, we have revisited the regulator’s chosen method for measuring bond risk (bond Solvency Capital Requirement), highlighting the main limitations, and thereby showing the need for an equity-type dampener within the regulatory bond risk measure. Secondly, we have built a proposal of a Dampener model based on a three-factor mean reversion which reduces the pro-cyclical effect of the Solvency II standard formula.
Why Some Futures Contracts Succeed and Others Fail: A Survey of Relevant Research
2014
Why do some futures contract succeed and others fail? Numerous researchers have provided case studies on both new and existing futures contracts, so this paper is fortunate to have a wealth of material from which to directly cite. Accordingly, this article will survey a number of textbooks, trade publications, academic papers, and think-tank articles from which one can distill lessons from over 160 years of (largely) U.S. experience with commodity trading. It turns out that even though the U.S. futures markets have evolved in a trial-and-error fashion, one can nonetheless identify the key...
OPEC Spare Capacity and the Term Structure of Oil Futures Prices
2014
This article looks into whether we can parsimoniously explain whether holding long futures positions in crude oil is a wise decision or not. It turns out that whether OPEC spare capacity is at comfortable levels or not would have been very helpful in making this decision, at least since the 1990s. Given the strength of this historical relationship, we can then speculate that it may be wise to examine current levels of OPEC spare capacity before deciding upon structural crude oil futures positions.
On the Rate of Return and Valuation of Non-Conventional Projects
2014
This paper provides a solution for evaluating non-conventional projects, firstly showing that the well-known modified internal rate of return does not correctly answer what investors want to measure. Even if one correctly uses the net present value criterion for capital budgeting, we show that it fails for non-conventional projects. Our contribution is thus twofold: To yield the correct rate of return for non-conventional projects and to allow practitioners to correctly calculate comparable net present values to take correct investment decisions.
Quantitative Portfolio Construction and Systematic Trading Strategies using Factor Entropy Pooling
2014
The Entropy Pooling approach is a versatile theoretical framework to process market views and generalised stress-tests into an optimal “posterior” market distribution, which is then used for risk management and portfolio management. Entropy Pooling can be implemented non-parametrically or parametrically. The non-parametric implementation with historical scenarios is more suitable for risk management applications. Here we introduce the parametric implementation of Entropy Pooling under a factor structure, which we name Factor Entropy Pooling. The factor structure reduces the dimension of the...
The Importance of the Structural Shape of Crude Oil Futures Curves
2014
In the past, one could confidently discuss how crude oil futures contracts typically trade in “backwardation.” By backwardation, one means that a near-month futures contract trades at a premium to deferred-delivery futures contracts. For example, Litzenberger and Rabinowitz (1995) pointed out that the NYMEX West Texas Intermediate (WTI) crude oil futures contract’s front-to-back futures spreads were backwardated at least 70% of the time between February 1984 and April 1992. This pattern was so persistent that these authors theorised why this should be the typical shape of the crude oil...
The History of Financial Derivatives: A 2-Part Feature
2014
This 2-part series discusses the emergence of financial derivatives after the collapse of the Bretton Woods accord in 1971. In Part 1, the paper explains the concepts that enabled financial derivatives markets to flourish, focusing on the required mathematical concepts. Part 2 continues with enumerating the business models that have been employed by successful commercial participants in the financial derivatives arena. A revisited version of this paper was published in the November/December 2015 issue of Corporate Finance Review.
Towards Conditional Risk Parity — Improving Risk Budgeting Techniques in Changing Economic Environments
2014
This paper introduces three distinct conditional risk parity strategies, explicitly designed to optimally respond to changes in state variables that have been used in the literature as proxies for the stochastically time-varying opportunity set. In an empirical analysis, the paper documents the superiority in various economic regimes of such conditional risk parity strategies with respect to standard unconditional risk parity techniques.
The Fund of Hedge Fund Selection Puzzle: A Pragmatic Approach to Identify the X-Factor
2014
We use the regime switching approach introduced in Pelletier (2006), and adapted by Giamouridis and Vrontos (2007) to the context of hedge fund portfolios, to design a new tactical style allocation factor. We then propose to leverage on this factor to identify fund of hedge fund managers who turn out to be good at capturing the upside while controlling for the downside risk. By so doing, we provide investors with a pragmatic though robust approach to address the fund of hedge fund selection puzzle.
Growth Optimal Portfolio Insurance For Long-Term Investors
2014
We solve for the growth-rate optimal multiplier of a portfolio insurance strategy in the general case with a locally risky reserve asset and stochastic state variables. The level of the optimal time-varying multiplier turns out to be lower than the standard constant multiplier of CPPI for common parameter values. As a consequence the outperformance of the growth-optimal portfolio insurance strategy (GOPI) does not come with higher risk. A revisited version of this paper is forthcoming in the Journal of Investment Management.
Tail Risk Of Equity Market Indices: An Extreme Value Theory Approach
2014
Value-at-risk (VaR) and conditional value-at-risk (CVaR) have become standard choices for risk measures in finance. Both VaR and CVaR are examples of measures of tail risk, or downside risk, because they are designed to exhibit a degree of sensitivity to large portfolio losses whose frequency of occurrence is described by what is known as the tail of the distribution: a part of the loss distribution away from the central region geometrically resembling a tail. In practice, VaR provides a loss threshold exceeded with some small predened probability, usually 1% or 5%, while CVaR measures the...
Optimising The Compression Cycle: Algorithms For Multilateral Netting In OTC Derivatives Markets
2014
This paper proposes and analyses a set of optimal compression algorithms for fungible derivatives. It finds that they all perform extremely well across a range of criteria and discusses their relative attributes. Although the focus is on the CDS market, the methods analysed here can be applied to other OTC derivative markets. If done optimally, compression is an effective counterparty risk mitigation technique that should be encouraged by regulators, especially as the benefits increase dramatically with the number of participants.
Index Transparency - A Survey Of European Investors' Perceptions, Needs And Expectations
2014
Between August and November 2013, EDHEC-Risk Institute surveyed 109 institutional investors from across Europe, including Europe’s largest pension and reserve funds, insurance and provident institutions and their asset management subsidiaries, to document their expectations and requirements with respect to index transparency and take stock of their perceptions of, and the extent of their support for, the main directions of the ongoing regulatory debate on indexing and financial benchmarks.
The EDHEC European ETF Survey 2013
2014
The latest edition of the European ETF Survey, which presents the results of a comprehensive survey of 207 European ETF investors, analyses the current practices and perceptions among ETF users in Europe and intends to shed light on trends within the European ETF market by comparing our results with those of our previous surveys. This year, the survey results show that ETF investors are still looking to increase or at least to maintain their use of ETFs and have a more favourable outlook on their use of alternative indexing products.
Do Multiple Credit Ratings Signal Complexity? Evidence from the European Triple-A Structured Finance Securities
2014
In much of the current research on market practices with respect to the use of credit ratings, the rating shopping hypothesis and the information production hypothesis feature prominently. Both of these hypotheses predict an inverse relationship between the number of ratings and a security’s funding cost; that is, more ratings will reduce funding costs and, conversely, fewer ratings will increase funding costs. This study finds precisely the opposite to have been the case for the mainstay of the structured finance securities market in Europe prior to 2007, namely the triple-A tranches of...
Comparing Different Regulatory Measures to Control Stock Market Volatility: A General Equilibrium Analysis
2014
In this paper, we compare the effects of different regulatory measures used to reduce excess volatility of stock-market returns, which is generated by investors trading on sentiment. The regulatory measures we study are the Tobin tax, shortsale constraints, and leverage constraints. The main contribution of our research is to evaluate these regulatory measures within the same dynamic, stochastic general equilibrium model of a production economy, so that one can compare both the direct and indirect effects of the different measures on the financial and real sectors within the same economic...
Dynamic Liability-Driven Investing Strategies: The Emergence Of A New Investment Paradigm For Pension Funds? A Survey Of The LDI Practices For Pension Funds
2014
A number of profound changes have taken place, which have collectively led to the emergence of a new investment paradigm for pension funds. The standard paradigm for pension fund investments, which used to be firmly grounded around one overarching foundational concept of the policy portfolio, is slowly but surely being replaced by a new, more modern, investment paradigm known as the dynamic liability-driven investing (DLDI) paradigm. This new paradigm has two main defining characteristics: on the one hand, a focus on the management of portfolio risk relative to the liabilities, as opposed to...
Improved Risk Reporting With Factor-Based Diversification Measures
2014
This paper analyses various measures of portfolio diversification, and explores the implication in terms of advanced risk reporting techniques. We use the minimal linear torsion approach (Meucci et al. (2013)) to turn correlated constituents into uncorrelated factors, and focus on the effective number of (uncorrelated) bets (ENB), the entropy of the distribution of risk factor contribution to portfolio risk, as a meaningful measure of the degree of diversification in a portfolio. In an attempt to assess whether a relationship exists between the degree of diversification of a portfolio and its...
Why Haven't Weather Derivatives Been More Successful as Futures Contracts? A Case Study
2014
Why have some seemingly promising futures contracts not succeeded in the recent past? This paper examines one such example, the weather derivatives market. First, it provides a brief history of weather derivatives contracts as well as a description of these contracts. Next it reviews customised over-the-counter (OTC) weather derivatives contracts, as provided by reinsurers, and then it reviews why futures contracts are not as successful a method of risk transfer. Lastly, it describes how weather exposures do not sufficiently match up against the criteria for the successful launch of a futures...
Why Haven't Uranium Futures Contracts Succeeded? A Case Study
2014
Why have some seemingly promising futures contracts not succeeded in the recent past? This paper examines one such example, the uranium futures market. It first provides some background on the uranium futures contract as well as a description of this contract, and then notes how the uranium market does not sufficiently match up against the criteria for the successful launch of a futures contract.
Why Haven't Pulp Futures Contracts Succeeded? A Case Study
2014
Why have some seemingly promising futures contracts not succeeded in the recent past? This paper examines one such example, the pulp market, first summarising the individual attempts at launching pulp futures contracts, and then noting how the pulp markets match up (or not) against the various criteria for the successful launch of a futures contract. A revisited version of this paper was published in the Volume 4, Issue 4, 2015 issue of the Journal of Governance and Regulation.
Who Needs Inflation Hedging? A Quantitative Analysis Of The Benefits Of Inflation-Linked Bonds, Real Estate And Commodities For Long-Term Investors With Inflation-Linked Liabilities
2014
This paper proposes an empirical analysis of the opportunity gains (costs) involved in introducing (removing) various assets with attractive inflation-hedging properties for long-term investors facing inflation-linked liabilities. Using formal intertemporal spanning tests, we find that interest rate risk dominates inflation risk so dramatically within instantaneous liability risk that introducing or removing inflation-linked bonds, or real estate and commodities, from their liability-hedging portfolio has relatively little impact on investors’ welfare from a short-term perspective.
Discussion of the Central Bank of Ireland discussion paper on loan origination by investment funds
2013
The Central Bank of Ireland has issued a discussion paper on loan origination by investment funds, in which it suggests that developing alternative sources of financing to bank loans may be beneficial to the real economy but requires the careful consideration of the potential development of "shadow banking" risks. In this response to the discussion paper, we argue that the development of alternative sources of financing is most relevant with regards to long-term private debt, in particular the financing of SMEs and infrastructure projects. The demand for such financing has been identified as...
Challenges Facing Commodity Futures Market Participants: The Anti-Speculation Cycle, the RORO Environment, and Position Limits
2013
Professor Scott Irwin of the University of Illinois has argued that there is a reasonably predictable “anti-speculation cycle” due to periodic bouts of inflation and deflation in commodity prices. Therefore, market participants have an obligation to periodically explain the economic role of futures trading and the role of speculators in these markets. This will be the main task of this article. In addition, this article will discuss two other challenges facing market participants: the impact of the Risk On / Risk Off (RORO) environment in managing commodity risk, and the prospects for the...
Commodity Strategies Based on Momentum, Term Structure and Idiosyncratic Volatility
2013
This article demonstrates that momentum, term structure and idiosyncratic volatility signals in commodity futures markets are not overlapping, which motivates the design of a new triple-screen strategy. Over the period between January 1985 and August 2011, systematically buying contracts with high past performance, high roll-yield and low idiosyncratic volatility, while shorting contracts with poor past performance, low roll-yields and high idiosyncratic volatility generates an average Sharpe ratio that is five times that of the S&P-GSCI. The triple-screen strategy dominates each of the...
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About EDHEC
Operating from campuses in Lille, Nice, Paris, London and Singapore, EDHEC is one of the world’s top 15 business schools. Fully international and directly connected to the business world, EDHEC commands a strong reputation for research excellence and the ability to train entrepreneurs and managers capable of breaking new ground. EDHEC functions as a genuine laboratory of ideas and produces innovative solutions valued by businesses. The School’s teaching is inspired by its research work and a focus on “learning by doing”, all with the aim of equipping people with the skills to succeed in business.
