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A conditional approach to hedge fund risks

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  • Teiletche, Jérôme
  • Pochon, Florent
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    Abstract

    This article applies a two-step conditional Bayesian approach to hedge fund risk. First, a mixture or-two normal distributions is estimated for a core asset; one distribution being identified as linked to a "quiet" regime and the other to a "hectic" regime. The conditional probabilities of each regime are then inferred and a mixture of distributions is deduced for peripheral assets. The core asset is alternatively chosen as the S&P index or the Baa/Treasuries yield spread whereas the peripheral assets are chosen to be the major hedge funds strategies over the period 1990-2004. This methodology has several advantages given specific features of hedge funds returns, notably non-linear exposure to standard assets returns and short sample history. Significant changes in the distribution (mean and standard deviation) of hedge fund returns are identified across regimes. Results are less clear-cut for the correlation with standard assets, as modifications can be imputed to a certain extent to a form of selection bias. An application of this methodology to stress tests on hedge funds portfolios is presented.

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    Bibliographic Info

    Paper provided by Paris Dauphine University in its series Economics Papers from University Paris Dauphine with number 123456789/682.

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    Date of creation: 2006
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    Publication status: Published in Journal of Alternative Investments, 2006, Vol. 9, no. 1. pp. 64-77.Length: 13 pages
    Handle: RePEc:dau:papers:123456789/682

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    Related research

    Keywords: Risk; Standard deviations; Hedging (finance); Mutual funds; Hedge funds; Finance;

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    1. Mark Mitchell, 2001. "Characteristics of Risk and Return in Risk Arbitrage," Journal of Finance, American Finance Association, American Finance Association, vol. 56(6), pages 2135-2175, December.
    2. John Y. Campbell & Glen B. Taksler, 2002. "Equity Volatility and Corporate Bond Yields," NBER Working Papers 8961, National Bureau of Economic Research, Inc.
    3. Vikas Agarwal, 2004. "Risks and Portfolio Decisions Involving Hedge Funds," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 17(1), pages 63-98.
    4. Fung, William & Hsieh, David A., 1999. "A primer on hedge funds," Journal of Empirical Finance, Elsevier, Elsevier, vol. 6(3), pages 309-331, September.
    5. Fung, William & Hsieh, David A, 1997. "Empirical Characteristics of Dynamic Trading Strategies: The Case of Hedge Funds," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 10(2), pages 275-302.
    6. Fung, William & Hsieh, David A, 2001. "The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 14(2), pages 313-41.
    7. Merton, Robert C, 1981. "On Market Timing and Investment Performance. I. An Equilibrium Theory of Value for Market Forecasts," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 54(3), pages 363-406, July.
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