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Recent Research: Highlights from April 2013

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"A Fund of Hedge Funds Under Regime Switching"
The Journal of Alternative Investments (Spring 2013)
David Saunders, Luis Seco, Christofer Vogt, and Rudi Zagst

This article investigates the use of a regime-switching model of returns for the asset allocation decision of a fund of hedge funds. In each time period, returns follow a multi-variate normal distribution from one of two possible regimes, corresponding to periods of “normal” and “distressed” markets. The prevailing regime in any given period is determined by the value of a two-state Markov chain. The case where serial correlation is absent and returns in different time periods are i.i.d. Gaussian mixture variables is also considered. The models are tested on empirical data and compared to a benchmark, assuming i.i.d. normally distributed returns. The results show that in a mean–variance framework, the use of regime switching can improve risk and performance measures. The importance of the sensitivity of optimal portfolio weights to the estimate of the probability of the distressed regime is discussed, and methods for calculating sensitivities are presented and illustrated on market data.

"The Inflation Risk Premium: Evidence from the TIPS Market"
The Journal of Fixed Income (Spring 2013)
Olesya V. Grishchenko and Jing-Zhi Huang

This article estimates inflation risk premia using data on prices of Treasury Inflation-Protected Securities (TIPS) from 2000 to 2008. The estimation approach is arbitrage-free, largely model-free, and easy to implement. It also distinguishes between TIPS yields and real yields by explicitly taking into account the three-month indexation lag of TIPS in the analysis. In addition, we consider three measures of TIPS liquidity, including one new measure based on TIPS prices only. We estimate the liquidity premium to be around 13 basis points over the full sample but substantially higher in the first subperiod. We find that the inflation risk premium is time-varying and, on average, considerably lower than suggested by various structural models. Depending on the proxy used for expected inflation, the unconditional 10-year inflation risk premium ranges from –9 basis points to 4 basis points over the full sample, and between 1 basis point and 6 basis points over the 2004–2008 subperiod.

"Effect of Being a Fallen Angel on Bond Ratings and Yields"
The Journal of Trading (Spring 2013)
Kelly Cai

This article investigates whether bond ratings serve as a basis for market prices of bonds. Unlike most previous work, which focused on rating changes, the author uses a new sample to consider bond ratings at issue. The author compares the yield spread of general high-yield bonds and high-yield bonds issued by fallen angels (firms that no longer carry an investment-grade rating). If investors totally depend on ratings, equally rated bonds should have the same yield spreads. This study finds, however, that bonds of identical ratings have different yield spreads. Specifically, for the BB/Ba rating category, yields of high-yield bonds issued by fallen angels are higher than the yields of similarly rated bonds issued by firms that have a speculative rate from the beginning. These findings suggest that bond ratings do not perfectly capture information related to bond characteristics in general. Results also suggest that rating agencies are too optimistic when rating high-yield bonds issued by fallen angels.

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