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Recent Research: Highlights from October 2012

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"Integration of Structured Finance Exposures in Basel II Model: Analytical Results"
The Journal of Fixed Income (Fall 2012)
Kilian Plank

For efficiency reasons or because of a lack of detailed data, financial institutions frequently treat structured finance securities similar to conventional fixed-income products such as bonds or loans, which are characterized by rating, correlation, and loss-given default. Structured finance securities, however, have a specific risk profile. They tend to concentrate losses in adverse states of the systematic risk factor. This fact implies that simply adopting risk parameters of conventional bonds or loans is an inappropriate technique. The author shows that, under the Basel II framework, tranches have to be modeled with an increased factor loading. They derive an analytical calibration procedure for the Basel II model that appropriately captures the risk profile of tranches. This finding not only allows for seamless integration of structured and conventional exposures in a portfolio model, but also offers insights into the concentration effects of tranches.

"Qualitative Hedge Fund Characteristics and Fund Performance: Changes Over Time"
The Journal of Alternative Investments (Fall 2012)
Rajesh K. Aggarwal, Jane Buchan, and Pierre Saint-Laurent

In this article, the authors examine three hedge fund governance characteristics—restrictions on investor liquidity, the presence of a high-water mark, and the level of fees charged to investors—that previously have been shown to be associated with superior hedge fund performance. Investor liquidity and high-water mark provisions, which were found to predict performance in earlier time periods, no longer do so. High fund fees are associated with better fund performance—but only because better managers are able to charge higher fees, not because higher fees make managers perform better. The authors conclude that simple, readily observable characteristics do not reveal superior performance.

"European Market Quality Pre-/Post-MiFID: A Panel Discussion of Metrics for Market Integrity and Efficiency"
The Journal of Trading (Fall 2012)
Frsederick H. deB. Harris and Elisa Maree DiMarco

Academics and practitioners discuss the state of capital market integration in Europe, specifically several metrics of market efficiency and market integrity pre- and post-MiFID (the Markets in Financial Instruments Directive). Security market integrity is measurable, and higher integrity lowers spreads and price impact, improving market efficiency. European spreads were among the lowest in the world well before MiFID. After MiFID, market manipulation dislocating the close fell in London but rose in Paris. Cumulative abnormal profit from trading ahead of price-sensitive announcements as a percentage of turnover remains half as great in Paris as in London. Trading on Chi-X ahead of price-sensitive announcements is lower than average for Europe, which on this metric has the highest integrity on a regional basis worldwide. Xetra exhibits the highest overall market integrity among all European exchanges and MTFs, pre- and post-MiFID. Price discovery efficiency in London and Paris has declined with the fragmentation of order flow post-MiFID.

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