Recent Research: Highlights from July 2010

"Index Volatility in Perspective" The Journal of Index Investing  (Summer 2010). Joanne M. Hill.

As the number of indexes and index-based investment products expands, it is critical for investors to understand relative index volatility. This article discusses the issues to consider when evaluating index risk and shares insights and data from the author’s recent historical index volatility analysis. The research evaluates the risk of index exposure from multiple perspectives—over time and on a relative basis—and encompasses U.S. equity, global equity, U.S. sector, U.S. Treasury, and select commodity market indexes. Specifically, the author explores how time dimension affects perception and assessment of risk, the cyclicality of volatility measures, patterns that may signal a future shift in risk, how index volatility measures trend compared to index return measures, and how index volatility behaves above and below the median, as well as under increasing levels of risk. Based on this research, the author shares several important insights, including the observation that risk can suddenly shift well above median levels for a given index, and those shifts often occur simultaneously across multiple indexes. As a result, significant short-term value changes may occur if portfolios are not modified to reduce risk when the inherent volatility of indexes rises. Alternatively, heightened risk may also present tactical investment opportunities for investors who have an ability to anticipate directional index moves.

"The Role of the Constant Recovery Assumption in the Subprime Bubble" The Journal of Alternative Investments (Summer 2010). Donald R. Chambers, Michael A. Kelly, Qin Lu.

Securitization of mortgages is believed to have contributed to the recent boom and bust in real estate. In particular, structured products with wide tranches of AAA-rated derivative securities are retrospectively vilified. A key issue has been to understand how such large tranches of securities could have been viewed as safe despite the apparent high risks of the underlying mortgages. In this article, the authors analyze the complex models and the models’parameters to estimate the risks of the structured securities. They find that the models themselves, not the inputted parameters, such as expected default rates and correlations, were responsible for inappropriate ratings. In particular, they find that the assumption of a constant recovery rate generated generous ratings for large tranches of securities even with reasonable parameter estimates. 

"Structural and Market Efficacy Implications of the Short-Sell Ban in Europe" The Journal of Trading (Summer 2010). Jose Marques, Mainak Sarkar.

This article seeks to estimate the impact of the ban imposed on short selling by various market regulators across Europe in late 2008, at the peak of the financial crisis. The authors select the STOXX 600 constituents as their universes and do an event study of the ban period, in contrast with the preand post ban-period for the same universe of stocks. In particular, the article reports what impact the ban had, if any, on the efficiency of the market (abnormal returns, volatility, etc.) and market microstructure variables (spread, shape of the order book, etc.), using tick data from Reuters. The authors find a deleterious effect on both sets of variables during the ban, even after controlling for the general crisis like market environment (using STOXX 600 stocks not under the purview of the ban). 

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