Recent Research: Highlights from April 2011
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“The Impact of Illiquidity and Higher Moments of Hedge Fund Returns on Their Risk-Adjusted Performance and Diversification Potential.” The Journal of Alternative Investment (Spring 2011). Laurent Cavenaile, Alain Coën, and Georges Hübner.
This article studies the joint impact of smoothing and fat tails on the risk–return properties of hedge fund strategies. First, the authors adjust risk and performance measures for illiquidity and the non-Gaussian distribution of hedge funds returns. They use two risk metrics: the Modified Value-at-Risk and a preference-based measure retrieved from the linear exponential utility function. Second, they revisit the hedge fund diversification effect with these adjustments for illiquidity. Their results report similar fund performance rankings and optimal hedge fund strategy allocations for both adjusted metrics. They also show that the benefits of hedge funds in portfolio diversification persist but tend to weaken after adjustments for illiquidity are made.
Strategic default behavior suggests that the default process is not only a matter of the inability to pay. Economic costs and benefits affect the incidence and timing of defaults. As with prior research, this article finds that people default strategically as their home value falls below the mortgage value (exercise the put option to default on their first mortgage). While some of these homeowners default on both first mortgages and second lien home equity lines, a large portion of the delinquent borrowers have kept their second lien current during the recent financial crisis. These second liens, which are current but stand behind a seriously delinquent first mortgage, are subject to a high risk of default. However, relatively few borrowers default on their second liens while remaining current on their first. This article explores the strategic factors that may affect borrower decisions to default on first vs. second lien mortgages. This study finds that borrowers are more likely to remain current on their second lien if it is a home equity line of credit (HELOC) rather than a closed-end home equity loan. Moreover, the size of the unused line of credit is an important factor. Interestingly, we find evidence that the various mortgage loss mitigation programs also play a role in providing incentives for homeowners to default on their first mortgages.
“The Exchange of Flow Toxicity.” The Journal of Trading (Spring 2011). David Easley, Marcos M López De Prado, Maureen O’Hara.
Flow toxicity can be measured in terms of the probability that a liquidity provider is adversely selected by informed traders. In previous papers the authors introduced the concept of Volume-synchronized Probability of Informed Trading (the VPIN* metric) and provided a robust estimation procedure. In this study, they discuss the asymmetric impact that an incorrect estimation of the VPIN metric has on a market maker’s performance. This asymmetry may be part of the explanation for the evaporation of liquidity witnessed on May 6th 2010. To mitigate that undesirable behavior, they present the specifications of a VPIN contract, which could be used to hedge against the risk of higher than expected levels of toxicity, as well as to monitor such risk. Among other applications, it would also work as an execution benchmark and a price discovery mechanism, since it allows for the externalization of market participants’ views of future toxicity.