Recent Research: Highlights from January 2012
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"Optimal Hedge Fund Allocation with Improved Estimates for Coskewness and Cokurtosis Parameters"
The Journal of Alternative Investments (Winter 2012)
Asmerilda Hitaj, Lionel Martellini, and Giovanni Zambruno
Since hedge fund returns are not normally distributed, mean–variance optimization techniques are not appropriate and should be replaced by optimization procedures incorporating higher-order moments of portfolio returns. In this context, optimal portfolio decisions involving hedge funds require not only estimates for covariance parameters but also estimates for coskewness and cokurtosis parameters. This is a formidable challenge that severely exacerbates the dimensionality problem already present with mean–variance analysis. This article presents an application of the improved estimators for higher-order co-moment parameters, in the context of hedge fund portfolio optimization. The authors find that the use of these enhanced estimates generates a significant improvement for investors in hedge funds. The authors also find that it is only when improved estimators are used and the sample size is sufficiently large that portfolio selection with higher-order moments consistently dominates mean–variance analysis from an out-of-sample perspective. Their results have important potential implications for hedge fund investors and hedge fund of funds managers who routinely use portfolio optimization procedures incorporating higher moments.
"Determinants of Primary Market Spreads on U.K. Residential Mortgage-Backed Securities and the Implications for Investor Reliance on Credit Ratings"
The Journal of Fixed Income (Winter 2012)
Frank J. Fabozzi and Dennis Vink
We provide empirical evidence about the credit factors that affect the pricing of newly issued residential mortgage-backed securities (RMBS) in the UK. Our findings add an important element to the current debate by regulators throughout the world regarding whether investors rely exclusively on credit ratings in making investment decisions. Our results show that credit factors such as subordination level and collateral type that are taken into account by credit rating agencies when assigning a rating still have a significant impact on the new issuance spread even after accounting for the credit rating. The implication is that investors do not rely exclusively on ratings.
"Inside the Opening Auction"
The Journal of Trading (Winter 2012)
Jeff Bacidore, Kathryn Berkow, and James Wong
The opening auction can provide appealing price and liquidity opportunities. However, the auction mechanics can be vague and complex. This article provides a consolidated and detailed explanation of the auction mechanics and available preauction information for the NYSE and NASDAQ markets. The authors analyze NYSE and NASDAQ imbalance data from January 2011 to June 2011 to profile auction behavior. Three takeaways are most important for traders. First, imbalance volume is not representative of all the buying and selling interest in the auction; rather, it is only a slice of the interest revealed by the exchange. Second, in the NASDAQ auction, liquidity forms before any imbalance information is published, so traders need to carefully calculate how much can be traded while avoiding impact. Finally, in the NYSE auction, opening liquidity can change from orders added or canceled at any time up until the auction, so traders need to actively monitor the published feed to avoid suddenly becoming a larger participant than intended.