EDHEC Publications
Response to ESMA Consultation Paper to Implementing Measures for the AIFMD
2011
Several regulatory initiatives are being taken in Europe and recommendations that will reshape the investment fund industry are being made. Existing regulations, such as UCITS, are being reshaped; the need for a regulation of depositaries has been acknowledged, and since the G20 there has been more focus on the monitoring of hedge funds. Many of these regulatory needs have converged in the alternative investment fund managers’ directive (AIFMD), which means that the AIFMD could become a unique framework that settles most of the questions related to the common framework for funds, fund...
EDHEC-Risk European Index Survey 2011
2011
As the choice of an index is a crucial step in both asset allocation and performance measurements, it is useful to investigate index use and perceptions about indices. The EDHEC-Risk European Index Survey 2011 analyses the current uses of and opinions on stock, bond and equity volatility indices with the aim of providing unique insight into the users’ perspective in the index industry. An article based on this survey was published in the Summer 2012 issue of the Journal of Index Investing.
Keynes Meets Markowitz: The Trade-off Between Familiarity and Diversification
2011
This paper develops a model of portfolio choice that nests the views of Keynes—who advocates concentration in a few familiar assets—and Markowitz—who advocates diversification across assets. It relies on the concepts of ambiguity and ambiguity aversion to formalize the idea of an investor's "familiarity" toward assets.
Improved Beta? A Comparison Of Index-Weighting Schemes
2011
This paper analyses a set of equity indices whose aim is to improve on capitalisation weighting and thus to provide “improved beta”. Four main weighting schemes are analysed: efficient indices, fundamental indices, minimum-volatility indices, and equal-weighted indices. Empirical results for US and Developed World data on these indices show that the average returns of all four alternative index construction methods are superior to those of cap-weighted equity indices in both universes and that, by several measures of risk-adjusted performance, they are likewise superior. A revisited version...
Long-Short Commodity Investing: Implications for Portfolio Risk and Market Regulation
2011
A number of policy-makers have blamed the decade-long rise in commodity prices and recent market volatility on the growing influence of financial investors and called for new regulation restricting their participation in commodity markets. Market financialisation has also led investors to worry about higher integration between commodity and traditional financial markets weakening the portfolio benefits of commodity investment. This study, produced with market data and support from CME Group, first examines the performance and risk characteristics of long-only commodity index investments...
Structured Equity Investment Strategies for Long-Term Asian Investors
2011
This publication show that a structured target-volatility strategy significantly improves both the downside and the upside of the return distribution relative to a fixed-mix strategy and also allows investors to benefit more from the upside potential when a capital guarantee overlay is applied. It shows how the explicit management of volatility reduces the cost of the capital protection. It also documents utility gains for risk-averse investors, with and without capital guarantee overlay, and makes the case for significant allocations to structured equity investment strategies with volatility...
Capturing the Market, Value, or Momentum Premium with Downside Risk Control: Dynamic Allocation Strategies with Exchange-Traded Funds
2011
There is extensive evidence that investment strategies based on momentum and value are attractive for portfolio managers who seek higher performances. Momentum and value are among the most robust return drivers in the cross section of expected returns. Dynamic risk budgeting methodologies such as Dynamic Core Satellite strategies (DCS) are used to provide risk-controlled exposure to different asset classes. We examine how to exploit the value and momentum anomalies using a DCS investment model. This paper shows that the DCS approach can boost portfolio returns while keeping downside risk...
Market Risks in Asset Management Companies
2011
This paper shows that revenues from a sample of publicly traded US asset management companies carry substantial market risks. Not only does this challenge the academic risk management literature about the predominance of operative risks in asset management. It also is at odds with current practice in asset management firms. Asset managers do not hedge market risks even though these risks are systematically built into the revenue generation process. A revisited version of this paper was published in Quantitative Finance, Volume 12, Issue 10, 2012.
A Review of the G20 Meeting on Agriculture: Addressing Price Volatility in the Food Markets
2011
This paper examines food price volatility in the context of the G20 meeting of agriculture ministers. In reviewing the evidence so far regarding the impact of commodity trading, speculation, and index investment on price volatility, the report finds that the evidence for the prosecution does not seem particularly compelling at this point.
A Short Note on the Tobin Tax: The Costs and Benefits of a Tax on Financial Transactions
2011
Almost each time volatility in equity, debt, or currency markets increases, there are cries to introduce a tax of financial transactions, first proposed in Tobin (1974). This tax is motivated by the view that the excess volatility in financial markets is the result of trading by "speculators"; thus, even a small tax on financial transactions would "throw some sand in the wheels" of financial markets, and hence, by slowing down the trading activity of speculators would reduce volatility.
Skin in the Game versus Skimming the Game: Governance, Share Restrictions and Insider Flows
2011
Hedge-fund managers justify share restrictions as means of protecting the common interest of the shareholders. However, this paper advances that such restrictions can adversely induce information asymmetry between managers and their clients about future fund flows. The paper demonstrates that share-restricted funds with recent outflows underperform funds with recent inflows by about 5.6% annually over 1998—2008. No such return spread is observed for funds with low-share restrictions. As managers may also act as investors in their own funds, the information asymmetry potentially allows them to...
A New Measure of Equity Duration: The Duration-Based Explanation of the Value Premium Revisited
2011
This paper proposes a new methodology to estimate a share's equity duration by using analysts' cash-flow forecasts. It finds that short duration is associated with high expected and realised returns — which cannot be attributed to the shares' systematic risk exposure as implied by the market beta. Instead, the paper shows that this measure of a company's average cash-flow maturity is a priced risk factor that has similar properties as the Fama-French factor B/M ratio. Our analysis suggests that the value premium might be a compensation for the value firms' higher exposure to cash-flow risk.
An Integrated Approach To Sovereign Wealth Risk Management
2011
Sovereign wealth funds (SWFs) typically have no direct earmarked liabilities. Nor should they, as the financial asset they represent is only part of total sovereign assets, which in turn guarantee all sovereign liabilities. The objective of this paper is to incorporate the economic balance sheet of the sovereign sponsor into the optimal asset allocation problem of the SWF. This paper outlines an easy to implement solution that nests well in the literature on SWFs. We show that economic leverage will reduce speculative demand but leave hedging demand (against fluctuations in the net fiscal...
Bond Liquidity Premia
2011
Asset pricing models of limits to arbitrage emphasize the role of funding conditions faced by financial intermediaries. In the US, the Treasury repo market is the key funding market and, hence, theory predicts that the liquidity premium of Treasury bonds share a funding liquidity component with risk premia in other markets. This paper identifies and measures the value of funding liquidity from the cross-section of bonds by adding a liquidity factor correlated with age to an arbitrage-free term structure model. A revisited version of this paper was published in the April 2012 issue of The...
Force-fitting CDS Spreads to CDS Index Swaps
2011
Issues of contemporaneity, liquidity, different restructuring clauses and market supply and demand, all contribute to the fact that the market quoted term structure of CDS index spreads does not always agree with the term structure of CDS index spreads implied by the CDS term structures of the constituent credits. A revisited version of this paper was published in the Spring 2011 issue of the Journal of Derivatives.
Into a Distant Mirror: the 1870s
2011
On October 16th, 2010, the front page of the Wall Street Journal (WSJ) carried a story entitled, “Flashback to 1870 as Cotton Hits Peak” (Cancryn and Cui, 2010). The article noted that cotton prices had not been this high since at least 1870. Since this WSJ µ article was published, cotton prices have continued to reach new highs. If one looks into the distant mirror of the 1870s, one can spot other parallels to our current circumstances beyond the similarly explosive cotton price rally. As a result, one can find some very interesting, and potentially useful, historical lessons to draw on from...
Intelligent Commodity Trading and Risk Management
2011
This paper discusses intelligent risk-management techniques and new product innovation in the commodity futures markets. However, it first reviews the century-plus debate on the role of commodity speculators, given the prevalent concerns that this activity may have a destabilizing impact on commodity prices.
Risk Parity - Rewards Risks and Research Opportunities
2011
Mean-Variance optimisation has come under great criticism recently, based on the poor performance experienced by asset managers during the global financial crisis. In response, an alternative approach, called Risk Parity, which proceeds by equalising risk contributions, has garnered much interest. This paper summarises the work of a group of leading researchers on Risk Parity. A revisited version of this paper was published in the Spring 2011 issue of the Journal of Investing.
Idiosyncratic Risk and the Pricing of Poorly-Diversified Portfolios
2011
A vast body of literature has documented the value premium and the small firm effect as pervasive stylized facts in empirical asset pricing and yet research has been largely unable to provide entirely convincing explanations of these phenomena. This paper examines the role of idiosyncratic risk in explaining the cross-sectional variation of stock returns in the context of a set of size- and value-sorted portfolios.
A Review of Corporate Bond Indices: Construction Principles, Return Heterogeneity, and Fluctuations in Risk Exposures
2011
This paper analyses two sets of four corporate investment-grade bond indices each, one for the US market and the other for the euro-denominated bond market. First, we review the uses of bond indices as well as the challenges involved. We then analyse the risk-return properties and the heterogeneity of the indices in each set. Although the indices in each market resemble each other, there are still some differences. Moreover, an analysis of the stability of the indices’ risk exposures (interest rate and credit risks) reveals very unstable measures over time and, perhaps most importantly, this...
Measuring High-Frequency Causality between Returns, Realised Volatility and Implied Volatility
2011
We provide evidence on two alternative mechanisms of interaction between returns and volatilities: the leverage effect and the volatility feedback effect. We stress the importance of distinguishing between realised volatility and implied volatility, and find that implied volatilities are essential for assessing the volatility feedback effect. We also study the impact of news on returns and volatility. We introduce a concept of news based on the difference between implied and realised volatilities (the variance risk premium) and find that a positive variance risk premium has more impact on...
A Variational Approach to Contracting under Imperfect Observations
2011
We consider a continuous time model of the project value process that can only be observed with noise, and we allow for the possibility that the manager in charge of the project can misrepresent the observed value. The manager is compensated by the shareholders, based on the filtering estimate of the project outcome. By means of a variational calculus methodology, novel for this kind of problems, we are able to compute in closed form the optimal pay-per-performance sensitivity of the compensation and the optimal misreporting action. We illustrate our theoretical predictions through a detailed...
Markets With Random Lifetimes and Private Values: Mean-Reversion and Option to Trade
2011
We consider a market in which traders arrive at random times, with random private values for the single traded asset. A trader’s optimal trading decision is formulated in terms of exercising the option to trade one unit of the asset at the optimal stopping time. We solve the optimal stopping problem under the assumption that the market price follows a mean-reverting diffusion process. The model is calibrated to experimental data taken from Alton and Plott (2010), resulting in a very good fit.
Direct and Indirect Effects of Index ETFs on Spot-Futures Pricing and Liquidity: Evidence from the CAC 40 Index
2011
This paper investigates how the introduction of an index security directly or indirectly impacts the underlying-index spot-futures pricing. Using intraday data for financial instruments related to the CAC 40 index, it does not find that the spot-futures price efficiency improvement observed after ETF introduction is explained either by the direct effect of ETF shares being used in arbitrage trades or by the indirect effect of ETF trading improving the liquidity of index stocks in the short run. A revisited version of this paper was published in the March 2014 issue of European Financial...
Correlation vs. Trends: A Common Misinterpretation
2011
Two common beliefs in finance are that (i) a high positive correlation signals assets moving in the same direction while a high negative correlation signals assets moving in opposite directions; and (ii) the mantra for diversification is to hold assets that are not highly correlated. This paper explains why both beliefs are not only factually incorrect, but can actually result in large losses in what are perceived to be well diversified portfolios.
The European Fund Management Industry Needs a Better Grasp of Non-financial Risks
2011
This publication looks at how non-financial risks and failures have impacted the regulatory agenda in Europe and traces the management of liquidity, counterparty, compliance, misinformation, and other financial risks in the fund industry. By identifying the distribution of risks and responsibilities in the industry, it examines how convergence between country regulations could be achieved. Finally, it assesses how fund unit-holders can best be protected with appropriate regulations, improved risk management practices, and greater transparency.
Idiosyncratic Risk and the Cross-Section of Stock Returns
2011
Idiosyncratic volatility has received considerable attention is the recent financial literature. Whether average idiosyncratic volatility has recently risen, whether it is a good predictor for aggregate market returns and whether it has a positive relationship with expected returns in the cross-section are still matters of active debate. We revisit these questions from a novel perspective, by taking the cross-sectional variance of stock returns as a measure of average idiosyncratic variance.
Optimal Design of Corporate Market Debt Programmes in the Presence of Interest-Rate and Inflation Risks
2011
This paper provides a joint quantitative analysis of capital structure decisions and debt structure decisions within a standard continuous-time capital-structure model. In the presence of interest rate and inflation risks, we are able to obtain quasi-closed form expressions for the price of various forms of indexed- and non-indexed bonds issued by the firm, which allows us to generate computationally efficient estimates for the optimal debt structure. Our analysis shows that debt-structure decisions have a strong impact on capital structure decisions. It also suggests that substantial...
The Elephant In The Room: Accounting And Sponsor Risks In Corporate Pension Plans
2011
EDHEC surveyed corporate pension funds, their sponsors, and advisers to assess how sponsors manage pension risk and how pension funds manage sponsor risk. There are 100 respondents to the survey; they manage pension funds assets of more than €730 billion (the assets of sponsoring companies are greater than €5.5 trillion). Sponsors that give their employees pension plans are subject to the risk of having to make additional contributions to make up for shortfalls in pension funds as well as to a more specific accounting risk that arises because of the arbitrary accounting assumptions that...
Limit Order Markets, High Frequency Traders and Asset Prices
2011
Do high frequency traders affect transaction prices? In this paper we derive the distribution of transaction prices in limit order markets populated by low frequency traders before and after the entrance of a high frequency trader (HFT). We find that in a market with an HFT, the distribution of transaction prices has more mass around the center and thinner far tails. The intra-trade duration decreases in proportion to the ratio of the low frequency orders arrival rates with and without the presence of the HFT; trading volume goes up in proportion to the same ratio.
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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.
