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Recent Research: Highlights from June 2013

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"An Investment Strategy in Active ETFs"
The Journal of Index Investing (Summer 2013)
Sharon Garyn-Tal

Previous evidence suggests that selectivity or active management positively affects mutual fund performance, hedge fund performance, and passive ETF performance. I examine whether active ETF performance is also positively affected by active management. First, I look at active ETF performance estimated via the Fama–French–Carhart four-factor model. Second, using weekly return data on 10 active ETFs for the period 2008–2012, I find an investment strategy in active ETFs that earns a positive risk-adjusted excess return, based on R2 as extracted from the regression of the ETFs’ excess return on the four-factors’ excess return.

"Investor Overreaction to Technical Insolvency and Bankruptcy Risks in the 2008 Stock Market Crash"
The Journal of Investing (Summer 2013)
Jia Wang, Gulser Meric, Zugang Liu, and Ilhan Meric

Thaler and De Bondt [1985] demonstrate that investors may overreact to economic events. Studying investor overreaction to economic events has been a popular research topic in finance. However, investor overreaction to certain firm characteristics during economic events has not received sufficient attention. In this article, we study investor overreaction to firm technical insolvency and bankruptcy risks in the 2008 stock market crash. We demonstrate that firms with high technical insolvency and bankruptcy risks lost more value relative to other firms in the 2008 crash. However, these firms gained more value relative to other firms in the post-crash market reversal, implying that investors overreacted to technical insolvency and bankruptcy risks in the 2008 crash. Although firms with a high bankruptcy risk also lost more value in the 1987 stock market crash, these firms did not gain more value relative to other firms in the post-crash market reversal, implying that there was no investor overreaction to bankruptcy risk in the 1987 crash.

"General Partners Anticipate a Slow and Steady Recovery for Private Equity in 2013: Manufacturing, Technology and Latin America Are Expected to Provide Compelling Investment Opportunities in the Year Ahead"
The Journal of Private Equity (Summer 2013)
Lee Duran, Scott Hendon, Kevin Kaden, Ryan Guthrie, and Dan Shea

The authors’ survey suggests that general partners anticipate a slow and steady recovery for private equity in 2013. To take the pulse of the industry and identify the key challenges and opportunities that will impact private equity in 2013, the private equity practice at BDO USA, LLP, conducted its fourth annual Perspective Private Equity Study from November through December 2012. This year’s study, which examined the opinions of more than 100 senior professionals at private equity firms throughout the United States, found that despite a disappointing year in 2012, private equity professionals remain confident in the industry’s sustained recovery.

"Counterparty Credit Risk and American Options"
The Journal of Derivatives (Summer 2013)
Peter Klein and Jun Yang

One of the many counterintuitive things students in a first course on options learn is that premature exercise of an American call option on a nondividend paying stock is a mistake, and that for a dividend-paying stock, early exercise is never rational except just before the stock goes ex-dividend. Efforts to incorporate counterparty credit risk in the calculation have suggested assuming no change in exercise policy and simply discount the projected future cash flows at a higher risky interest rate. Others have argued that counterparty default should never happen with American options because the holder will exercise just before the counterparty defaults and effectively step in front of the other creditors to be paid in full.

Klein and Yang show that these ideas are incorrect. Early exercise gives up the option’s time value, so that even when imminent counterparty default is perfectly predictable, there is still a cost to exercise for credit reasons. Moreover, properly taking counterparty risk into account leads to optimal exercise behavior different from that in the nonvulnerable case, so simply discounting the same cash flows at a different rate undervalues the vulnerable option. The difference is particularly important when counterparty risk is wrong-way risk, such that the counterparty’s credit weakens under the same conditions that the option is in the money.

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