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How Are Derivatives Used? Evidence from the Mutual Fund Industry

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  • Jennifer Koski
  • Jeffrey Pontiff

Abstract

Approximately 20 percent of the 675 equity mutual funds analyzed in this paper invest in derivatives. We compare the return distributions of equity mutual funds that invest in derivatives to those that do not. We also analyze the use of derivatives to affect intertemporal changes in fund risk. Equity mutual funds that invest in derivatives have similar risk and similar net return performance in those that do not. Change in fund risk is negatively related to past performance, but derivatives allow funds to dampen these changes. We interpret these results as consistent with the hypothesis that managers are slow to respond to unexpected cash flows, and inconsistent with gaming of incentive compensation systems. This paper was presented at the Financial Institutions Center's May 1996 conference on "

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Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 96-27.

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Date of creation: May 1996
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Handle: RePEc:wop:pennin:96-27

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  1. Gary Gorton & Richard Rosen, 1995. "Banks and Derivatives," NBER Chapters, in: NBER Macroeconomics Annual 1995, Volume 10, pages 299-349 National Bureau of Economic Research, Inc.
  2. Pontiff, Jeffrey, 1995. "Closed-end fund premia and returns Implications for financial market equilibrium," Journal of Financial Economics, Elsevier, vol. 37(3), pages 341-370, March.
  3. Chevalier, J. & Ellison, G., 1996. "Risk Taking by Mutual Funds as a Response to Incentives," Working papers 96-3, Massachusetts Institute of Technology (MIT), Department of Economics.
  4. Ippolito, Richard A, 1992. "Consumer Reaction to Measures of Poor Quality: Evidence from the Mutual Fund Industry," Journal of Law and Economics, University of Chicago Press, vol. 35(1), pages 45-70, April.
  5. Robert C. Merton, 1995. "Financial Innovation and the Management and Regulation of Financial Institutions," NBER Working Papers 5096, National Bureau of Economic Research, Inc.
  6. Shanken, Jay, 1990. "Intertemporal asset pricing : An Empirical Investigation," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 99-120.
  7. Bookstaber, Richard & Clarke, Roger, 1984. "Option Portfolio Strategies: Measurement and Evaluation," The Journal of Business, University of Chicago Press, vol. 57(4), pages 469-92, October.
  8. Mark Grinblatt & Sheridan Titman, . "Adverse Risk Incentives and the Design of Performance-Based Contracts," Rodney L. White Center for Financial Research Working Papers 21-88, Wharton School Rodney L. White Center for Financial Research.
  9. Merton, Robert C & Scholes, Myron S & Gladstein, Mathew L, 1978. "The Returns and Risk of Alternative Call Option Portfolio Investment Strategies," The Journal of Business, University of Chicago Press, vol. 51(2), pages 183-242, April.
  10. S. James Press, 1967. "A Compound Events Model for Security Prices," The Journal of Business, University of Chicago Press, vol. 40, pages 317.
  11. Mark Grinblatt & Sheridan Titman, 1989. "Adverse Risk Incentives and the Design of Performance-Based Contracts," Management Science, INFORMS, vol. 35(7), pages 807-822, July.
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