Recent Research: Highlights from January 2014

"Hedge Funds versus Hedged Mutual Funds: An Examination of Equity Long/Short Funds"
The Journal of Alternative Investments (Winter 2014)
David McCarthy

This article offers comparative analyses of equity long/short mutual funds and equity long/short hedge funds and indices. It first identifies a universe of liquid alternative mutual funds employing an equity long/short investment strategy similar to most equity long/short private hedge funds. It then provides a general profile of these mutual funds (e.g., size, start dates, sponsorship) before comparing their equity exposure and investment performance to that of private placement equity long/short hedge funds and indices. Based on the data analyzed, the article concludes that, as a group, diversified single-manager equity long/short mutual funds offer similar equity exposures and do not perform materially differently from comparable private placement hedge funds, at least as represented by leading hedge fund indices.

"Mortgage Option Deltas"
The Journal of Fixed Income (Winter 2014)
Michael Landrigan and Danny Sun

Mortgage options are European options on TBA contracts that are forwards on securitized pools of agency-backed mortgages. Because of the significant negative convexity of TBAs, calculation of option deltas is a delicate issue. It is common to model TBA options with the S-curve framework. Mortgage option prices, however, may be significantly higher than such a model predicts. There are various ways of dealing with this price discrepancy, including adjusting the TBA DV01 curve, applying a scaling factor to swaption volatilities used in calibration, or adding an extra rate-independent variance to TBA prices. These different modifications of the base S-curve framework may lead to the same option prices but different deltas. In this article, the authors estimate deltas using local price volatility and compare the deltas resulting from different modifications of the base S-curve framework to these “model-free” estimates. The analysis is primarily important for risk management in terms of mark-to-the-market pricing of mortgage options and its implication for the deltas. Although in practice only at-the-money mortgage options are marked to market, the authors also discuss the implications for skew and some valuation implications.

"What Makes an Exchange a Unique Institution?"
The Journal of Trading (Winter 2014)
Robert A. Schwartz and John Aidan Byrne

On October 4, 2011, a high-level financial markets conference, “The Economic Function of a Stock Exchange,” was held at Baruch College in New York City. Andrew Brooks, the well-known buy-side trading executive (T. Rowe Price Associates, Inc.) moderated a thought-provoking panel, “What Makes an Exchange a Unique Institution?” In this article, we present the edited transcript of that panel, with footnotes and expanded material from subsequent interviews with the eminent panelists: Alfred Berkeley (then at Pipeline Trading Systems, LLC), Gary Katz (International Securities Exchange), William O’Brien (Direct Edge), Brett Redfearn (J.P. Morgan Securities), and Asani Sarkar (Federal Reserve Bank of New York).