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Exploiting skewness to build an optimal hedge fund with a currency overlay

  • C. J. Adcock
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    This paper documents an investigation into the use of portfolio selection methods to construct a hedge fund with a currency overlay. The fund, which is based on number of international stock and bond market indices and is constructed from the perspective of a Sterling investor, allows the individual exposures in the currency overlay to be optimally determined. As well as using traditional mean variance, the paper constructs the hedge funds using portfolio selection methods that incorporate skewness in the optimisation process. These methods are based on the multivariate skewnormal distribution, which motivates the use of a linear skewness shock. An extension to Stein's lemma gives the ability to explore the mean-variance-skewness efficient surface without the necessity to be concerned with the precise form of an individual investor's utility function. The results suggest that it is possible to use mean variance optimisation methods to build a hedge fund based on the assets and return forecasts described. The results also suggest that the inclusion of a skewness component in the optimisation is beneficial. In many of the cases reported, the skewness term contributes to an improvement in performance over and above that given by mean variance methods.

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    Article provided by Taylor & Francis Journals in its journal The European Journal of Finance.

    Volume (Year): 11 (2005)
    Issue (Month): 5 ()
    Pages: 445-462

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    Handle: RePEc:taf:eurjfi:v:11:y:2005:i:5:p:445-462
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    1. Panayiotis Theodossiou, 1998. "Financial Data and the Skewed Generalized T Distribution," Management Science, INFORMS, vol. 44(12-Part-1), pages 1650-1661, December.
    2. Chunhachinda, Pornchai & Dandapani, Krishnan & Hamid, Shahid & Prakash, Arun J., 1997. "Portfolio selection and skewness: Evidence from international stock markets," Journal of Banking & Finance, Elsevier, vol. 21(2), pages 143-167, February.
    3. Samuelson, Paul A, 1970. "The Fundamental Approximation Theorem of Portfolio Analysis in terms of Means, Variances, and Higher Moments," Review of Economic Studies, Wiley Blackwell, vol. 37(4), pages 537-42, October.
    4. C. J. Adcock, 2003. "An Empirical Study of Portfolio Selection for Optimally Hedged Portfolios," Multinational Finance Journal, Multinational Finance Journal, vol. 7(1-2), pages 85-106, March-Jun.
    5. McDonald, James B. & Xu, Yexiao J., 1995. "A generalization of the beta distribution with applications," Journal of Econometrics, Elsevier, vol. 66(1-2), pages 133-152.
    6. Richard Harris & C. Coskun Kucukozmen & Fatih Yilmaz, 2004. "Skewness in the conditional distribution of daily equity returns," Applied Financial Economics, Taylor & Francis Journals, vol. 14(3), pages 195-202.
    7. Gibbons, Michael R & Ross, Stephen A & Shanken, Jay, 1989. "A Test of the Efficiency of a Given Portfolio," Econometrica, Econometric Society, vol. 57(5), pages 1121-52, September.
    8. Glen, Jack & Jorion, Philippe, 1993. " Currency Hedging for International Portfolios," Journal of Finance, American Finance Association, vol. 48(5), pages 1865-86, December.
    9. McDonald, James B. & Newey, Whitney K., 1988. "Partially Adaptive Estimation of Regression Models via the Generalized T Distribution," Econometric Theory, Cambridge University Press, vol. 4(03), pages 428-457, December.
    10. de Roon, F.A. & Nijman, T.E. & Werker, B.J.M., 1998. "Testing for mean-variance spanning with short sales constraints and transaction costs : The case of emerging markets," Discussion Paper 1998-07, Tilburg University, Center for Economic Research.
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