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Recent Research: Highlights from July 2012

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"Specification Risk and Calibration Effects of a Multifactor Credit Portfolio Model"
The Journal of Fixed Income (Summer 2012)
Gregor Dorfleitner, Matthias Fischer, and Marco Geidosch

This article examines a crucial source of specification risk when calibrating a typical industry-type, Merton-based credit portfolio model. It emerges from the necessity of having to choose a proxy for creditworthiness. In addition to equity prices and asset values, which are the classical choices, the authors consider credit default swap (CDS) spreads and expected default frequencies (EDF, from Moody’s KMV) as alternatives. Based on 40 large European companies from different industries, the authors calibrate a macroeconomic factor model with an OLS regression analysis for each specification and calculate the corresponding economic capital. Eighteen macroeconomic and financial variables are considered as risk factors. Their findings are: a) on average, 2 to 3 risk factors are needed to adequately model creditworthiness on the obligor level, b) stock market variables are the most important risk factors, c) model-implied credit correlation is extremely sensitive to the choice of the proxy for creditworthiness, and d) only the EDF specification leads to less economic capital compared with regulatory capital, according to Basel II, while it is exceeded substantially by all other specifications. In particular, credit correlation in the CDS specification by far exceeds any estimate mentioned in the literature. Most important, the authors show that the economic capital of their sample portfolio can be reduced by 78%, depending on which variable is chosen as a proxy for creditworthiness.

"On the Market-Timing Ability of Factor-Based Hedge Fund Clones"
The Journal of Alternative Investments (Summer 2012)
Brian T. Hayes

Hedge fund clones systematically mimic features of hedge fund returns. The author constructs clones of hedge fund indexes using several factor models and estimation intervals. Exposures of clones to asset and style factors vary over time, and excess returns from tactical exposure adjustments (i.e., market timing) are a potentially important source of returns. Clone market-timing ability is measured three ways: a regression on the factors used in construction; a multi-time scale attribution model; and directly from clone exposures. The author does not find evidence of market-timing ability in clones. Because the target hedge fund indexes do not exhibit market-timing ability—possibly an artifact of hedge funds’ security-selection ability—he also constructs clones of CommodityTradingAdvisor and Macro indexes that display timing ability. Clones of these latter indexes generally do not exhibit market-timing ability either. Lagged data and optionlike hedge fund strategies pose challenges to market timing in factor-based clones.

"Cluster Analysis for Evaluating Trading Strategies"
The Journal of Trading (Summer 2012)
Jeff Bacidore, Kathryn Berkow, Ben Polidore, and Nigam Saraiya

In this article, we introduce a new methodology to empirically identify the primary strategies used by a trader using only post-trade fill data. To do this, we apply a well-established statistical clustering technique called k-means to a sample of progress charts, representing the portion of the order completed by each point in the day as a measure of a trade’s aggressiveness. Our methodology identifies the primary strategies used by a trader and determines which strategy the trader used for each order in the sample. Having identified the strategy used for each order, trading cost analysis can be performed by strategy. We also discuss ways to exploit this technique to characterize trader behavior, assess trader performance, and suggest the appropriate benchmarks for each distinct trading strategy.

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