EDHEC Publications
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.
Asset Prices with Heterogeneity in Preferences and Beliefs
2011
This paper studies asset prices in a dynamic, continuous-time, general-equilibrium endowment economy where agents have power utility and differ with respect to both beliefs and their preference parameters for time discount and risk aversion. It solves in closed form for the following quantities: optimal consumption and portfolio policies of individual agents; the riskless interest rate and market price of risk; the stock price, equity risk premium, and volatility of stock returns; and, the term structure of interest rates. A revisited version of this paper was published in the Review of...
The Alpha of a Market Timer
2011
Portfolio managers claim to be able to generate abnormal returns through either superior asset selection or market timing. The Treynor and Mazuy (TM) model is the most used return-based approach to isolate market timing skills, but all existing corrections of the regression intercept can be manipulated by a manager who can trade derivatives. This paper revisits the TM model by applying the original option replication approach proposed by Merton. It exploits both the linear and the quadratic coefficients of the TM regression to assess the replicating cost of the cheapest option portfolio with...
Improving Portfolio Selection Using Option-Implied Volatility and Skewness
2011
The objective of this paper is to examine whether one can use option-implied information to improve the selection of portfolios with a large number of stocks, and to document which aspects of option-implied information are most useful for improving their out-of-sample performance. Portfolio performance is measured in terms of four metrics: volatility, Sharpe ratio, certainty-equivalent return and turnover. A revisited version of this paper was published in the December 2013 issue of the Journal of Financial and Quantitative Analysis.
A Hedge Fund Investor's Guide to Understanding Managed Futures
2011
Managed futures strategies are a niche-within-a-niche in the capital markets. Despite this status, managed futures have become of particular interest to hedge fund investors. This paper discusses why this has become the case by focusing on this strategy’s unique diversification properties. It also briefly covers the main characteristics of this investment category, its underlying sources of return, and alternative statistical measures that are appropriate for comparing managed futures investments with hedge fund investments.
How to Construct Fundamental Risk Factors?
2011
This paper proposes an alternative way to construct the Fama and French (1993) empirical risk factors. Without losing in significance power, in beta consistency or in factor efficiency compared to the Fama and French factors, our technique insulates the effects of other sources of risk as much as possible when evaluating one risk factor.
Option Pricing and Hedging in the Presence of Basis Risk
2011
This paper addresses the problem of option hedging and pricing when a futures contract, written either on the underlying asset or on some imperfectly correlated substitute for the underlying asset, is used in the dynamic replication of the option payoff. In the presence of unspanned basis risk modeled as a Brownian bridge process, which explicitly accounts for the convergence of the basis to zero as the futures contract approaches maturity, we are able to obtain an analytical expression for the optimal hedging strategy and corresponding option price. Empirical analysis suggests that the...
Optimal Contracting with Effort and Misreporting
2011
We propose a new continuous time contracting model, where the project value process can only be observed with noise, and there are two sources of moral hazard: effort and misreporting. Using calculus of variation techniques, we are able to find the optimal pay-per-performance sensitivity (PPS) of the contract offered to the manager, as well as optimal effort and misreporting action via a second order ordinary differential equation with time dependent coefficients. Our findings indicate that the agent will apply a higher level of effort and misreporting than if only one of those actions was...
Assessing Misspecified Asset Pricing Models with Empirical Likelihood Estimators
2011
Hansen and Jagannathan (1997) compare misspecified asset pricing models based on least-square projections on a family of admissible stochastic discount factors. We extend their fundamental contribution by considering Minimum Discrepancy projections where misspecification is measured by a family of convex functions that take into account higher moments of asset returns. A revisited version of this paper was published in the October 2012 issue of the Journal of Econometrics.
Asset Allocation with Shadow Assets
2011
The wealth of most investors contains both financial assets as well as non-financial assets. This paper defines shadow assets as (mostly) non-financial and non-tradable assets that are exogenous to the investor’s asset allocation decision. Examples for shadow assets are human capital, non-financial sovereign assets (e.g. underground oil reserves) the present value of future alumni contributions for university endowments or the non-listed family business for the client of a family office. Allocations to these shadow assets can hardly be changed and yet their existence will change the investor’...
A Post-crisis Perspective on Diversification for Risk Management
2011
Since the global financial crisis of 2008, improving risk management practices—management of extreme risks, in particular—has been a hot topic. The postmodern quantitative techniques suggested as extensions of mean-variance analysis, however, exploit diversification as a general method. Although diversification is most effective in extracting risk premia over reasonably long investment horizons and is a key component of sound risk management, it is ill-suited for loss control in severe market downturns. Hedging and insurance are better suited for loss control over short horizons. In...
Case Studies and Risk Management in Commodity Derivatives Trading
2011
Until recently, one could only gain expertise in commodity-derivatives relationships if one had worked in niche commodity-processor companies or in banks that specialised in hedging project risk for natural-resource companies. The contribution of this article is to help fill the knowledge gap in the risk management of commodity derivatives trading.
Never the Twain Shall Meet? Addressing the Disconnect between Banks’ Financial and Regulatory Reporting
2011
This paper reviews the arguments for and against the decoupling of capital ratio calculations based on IFRS from those based on Basel II. We analyse recent trends in both accounting and regulatory supervision after the financial crisis and identify areas where there are still deficiencies in the transparency of IFRS-based financial reports and regulatory-based capital disclosures and calculations. We find that the variation in disclosure practices across IFRS and BIS-based capital estimations is significant for a sample of major European banks.
Giants at the Gate: On the Cross-Section of Private Equity Investment Returns
2011
This paper examines the determinants of private equity returns using a newly constructed worldwide database of 7,500 investments made over forty years. The median investment IRR (PME) is 21% (1.3), gross of fees. One in ten investments goes bankrupt, whereas one in four has an IRR above 50%. Only one in eight investments is held for less than two years, but such investments have the highest returns. The scale of private equity firms is a significant driver of returns: investments held at times of a high number of simultaneous investments underperform substantially.
Introducing a New Form of Volatility Index: The Cross-Sectional Volatility Index
2011
This paper introduces a new form of volatility index, the cross-sectional volatility index. Through formal central limit arguments, it shows that the cross-sectional dispersion of stock returns can be regarded as an efficient estimator for the average idiosyncratic volatility of stocks within the universe under consideration. Among the key advantages of the cross-sectional volatility index measure over currently available measures are its observability at any frequency, its model-free nature, and its availability for every region, sector, and style of the world equity markets, without the...
Diversification in Funds of Hedge Funds: Is it Possible to Overdiversify?
2011
Samuelson (1967) argues that as a general matter it is easy to show that investors should be maximally diversified. For this reason many institutions are attracted to diversified portfolios of hedge funds, referred to as Funds of Hedge Funds (FOFs). In this paper we examine a new database that separates out for the first time the effects of diversification (the number of underlying hedge funds) from scale (the magnitude of assets under management). We find with others that the variance reducing effects of diversification peter out once FOFs hold more than 20 underlying hedge funds. Yet the...
Media and Investment Management
2010
This paper measures the differential impact of alternative media outlets. We classify news items about equity hedge funds over 1999 to 2008 into three source groups: General newspapers, Specialized magazines, and Corporate Communication. Applying a textual analysis to news items, we uncover three types of media biases. First, a reporting style bias, that is, when a fund is covered by multiple sources at the same time, the sentiment is most positive in Corporate coverage and least in General coverage. The differences in source sentiment are more significant in cases of exclusive coverage,...
An Integrated Approach To Asset-Liability Management: Capital Structure Choices, Pension Fund Allocation Decisions And The Rational Pricing Of Liability Streams
2010
Correctly assessing the value of a pension plan in deficit with a weak sponsor company is a real challenge given that no comprehensive model is currently available for the joint quantitative analysis of capital structure choices, pension fund allocation decisions and their impact on rational pricing of liability streams.
EDHEC-Risk European Private Wealth Management Survey
2010
A survey drawing on responses from 159 European private wealth managers, the three main findings of which are: Private wealth managers see the relationships they forge with their clients as the principle source of the value they add but they fail to exploit this close relationship to customise the services they offer their clients (when portfolios are designed for clients, market factors are taken into account more frequently than are the individual characteristics of the clients); Private wealth managers fail, on the whole, to provide state-of-the art means of horizon-dependent asset...
Does Finance Theory Make the Case for Capitalisation- Weighted Indexing?
2010
Proponents of cap-weighted stock market indices often argue that such indices provide efficient risk/return portfolios. This paper reviews the evidence in the academic literature and concludes that only under very unrealistic assumptions would such indices be efficient investments. In the presence of realistic constraints and frictions, cap-weighted indices cannot, according to the academic literature, be expected to be efficient investments. A revisited version of this working paper was published in the Fall 2011 issue of the Journal of Index Investing.
Asset-Liability Management Decisions For Sovereign Wealth Funds
2010
This paper proposes a quantitative dynamic asset allocation framework for sovereign wealth funds, modelled as large long-term investors that manage fluctuating revenues typically emanating from budget or trade surpluses in the presence of stochastic investment opportunity sets. The optimal asset allocation strategy takes into account the stochastic features of the sovereign fund endowment process (where the money is coming from), the stochastic features of the sovereign fund's expected liability value (what the money is going to be used for), and the stochastic features of the assets held in...
Risk Reduction in Style Rotation
2010
This paper investigates the potential improvement in the implementation of style rotation strategies by techniques addressing estimation errors. We select two approaches that have recently stood out in the statistics and econometric literature and have been applied to portfolio construction literature. One builds on regularization methods which address estimation error by focusing on the weights of the constructed portfolios. And a second method that uses pooled forecasts obtained across different observation windows. Thus it focuses on minimizing estimation error in the moments of the return...
A Suggestion for Remedying the Overstated Performance of Non-Investable Hedge Fund Indices
2010
Investable indices tend to recursively underperform their non-investable versions. In light of recent events, we can wonder whether the liquidity crisis that occurred in the wake of the Lehman collapse and had a significant impact on the performance of hedge fund strategies (more particularly on the strategies that are exposed to credit risk) has increased this excess return or not. In this respect, it would be interesting to compare the excess returns of non-investable indices and those of their investable counterparts before and after 2008.
Alternative Measurement Bases in Pension Accounting: A Simulation Analysis
2010
This paper explores the financial statement implications of alternative measurement bases underlying defined benefit pension accounting rules via a simulation analysis. Simulation analysis can be used to examine the effect of alternative discount rate assumptions on the strength of associations between an economic or generational accounting basis, an actuarial funding basis of measurement and two alternative accounting measurement bases of pension assets and liabilities; value-in-use and value-in-exchange. Accounting measures are found to be more highly correlated with economic unfunded...
From Deterministic To Stochastic Life-Cycle Investing: Implications For The Design Of Improved Forms Of Target Date Funds
2010
In an attempt to address the concern over financially illiterate individuals being increasingly responsible for investment decisions related to retirement risk, the financial industry has started to design dedicated mutual fund products known as target date funds. These funds, whose aim is to provide investors with one-stop solutions to their life-cycle investment needs, typically propose a deterministic decrease of equity allocation until a date called the target date of the fund. This approach, however, has been found inconsistent with the prescriptions of standard life-cycle investment...
New Frontiers In Benchmarking And Liability-Driven Investing
2010
Meeting the challenges of modern investment practice involves the design of novel forms of investment solutions, as opposed to investment products, customised to meet investors' long-term objectives while respecting the short-term (regulatory or otherwise) constraints they have to face. This paper argues that such new forms of investment solutions should rely on the use of improved performance-seeking and liability-hedging building-block portfolios, as well as on the use of improved dynamic allocation strategies.
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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.
