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Hedge fund dynamic market sensitivity

  • Jiaqi Chen
  • Michael L. Tindall

Many hedge funds attempt to achieve high returns by employing leverage. However, it is difficult to track the degree of leverage used by hedge funds over time because detailed timely information about their positions in asset markets is generally unavailable. This paper discusses how to combine shrinkage variable selection methods with dynamic regression to compute and track hedge fund leverage on a time-varying basis. We argue that our methodology measures leverage as well as hedge fund sensitivity to markets arising from other sources. Our approach employs the lasso variable selection method to select the independent variables in equations of hedge fund excess returns. With the independent variables selected by the lasso method, a state space model generates the parameter estimates dynamically. The hedge fund market sensitivity indicator is the average of the absolute values of the parameters in the excess return equations. Our indicator peaks at the time of the Long Term Capital Management meltdown in 1998 and again at a critical time in the 2008 financial crisis. In the absence of direct information from hedge fund balance sheets, our approach could serve as an important tool for monitoring market sensitivity and financial distress in the hedge fund industry.

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File URL: http://www.dallasfed.org/assets/documents/banking/occasional/1201.pdf
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Paper provided by Federal Reserve Bank of Dallas in its series Occasional Papers with number 12-1.

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Date of creation: 2012
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Handle: RePEc:fip:feddop:2012_001
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  1. Getmansky, Mila & Lo, Andrew & Makarov, Igor, 2003. "An Econometric Model of Serial Correlation and Illiquidity In Hedge Fund Returns," Working papers 4288-03, Massachusetts Institute of Technology (MIT), Sloan School of Management.
  2. Gupta, Anurag & Liang, Bing, 2005. "Do hedge funds have enough capital? A value-at-risk approach," Journal of Financial Economics, Elsevier, vol. 77(1), pages 219-253, July.
  3. Vikas Agarwal, 2004. "Risks and Portfolio Decisions Involving Hedge Funds," Review of Financial Studies, Society for Financial Studies, vol. 17(1), pages 63-98.
  4. Markus K. Brunnermeier & Stefan Nagel, 2004. "Hedge Funds and the Technology Bubble," Journal of Finance, American Finance Association, vol. 59(5), pages 2013-2040, October.
  5. Patrick M McGuire & Kostas Tsatsaronis, 2008. "Estimating hedge fund leverage," BIS Working Papers 260, Bank for International Settlements.
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