Expert answer:INVESTMENT RISK MANAGEMENT
Expert answer:Investment Risk Management– Assignment Instructions Evaluate Options, Futures, and Swaps Examine derivative securities: options, futures, and swaps. Investors and financial institutions that make use of these derivative securities to take positions are either speculators or hedgers. Speculators are attempting to predict the direction of some economic or market variable and generate gains on those predictions using derivative securities. Hedgers will have a specific operational risk that could be transferred using these derivative securities. A call option is the right to buy an asset at an agreed-upon exercise price. A put option is the right to sell an asset at a given exercise price. American-style options allow exercise on or before the expiration date. European options allow exercise only on the expiration date. Most traded options are American in nature. Options are traded on stocks, stock indexes, foreign currencies, fixed-income securities, and several futures contracts. Options can be used either to lever up an investor’s exposure to an asset price or to provide insurance against volatility of asset prices. Popular option strategies include covered calls, protective puts, straddles, spreads, and collars. Course Learning Outcomes 5.0. Compare and contrast values and risk Portfolio performance-international diversification, and hedge funds Support your paper with minimum of seven (7) scholarly resources. In addition to these specified resources, other appropriate scholarly resources, including older articles, may be included. Length: 5-7 pages not including title and reference pages Professor Overview: Futures, Swaps, and Risk Management According to Bodie, Kane, and Marcus (2014), investors such as hedge funds use hedging strategies to create market-neutral bets on perceived instances of relative mispricing between two or more securities. They are not arbitrage strategies, but pure plays on a particular perceived profit opportunity. Interest rate futures contracts may be written on the prices of debt securities (as in the case of Treasury-bond futures contracts) or on interest rates directly (as in the case of Eurodollar contracts). Swaps, which call for the exchange of a series of cash flows, may be viewed as portfolios of forward contracts. Each transaction may be viewed as a separate forward agreement. However, instead of pricing each exchange independently, the swap sets one “forward price” that applies to all of the transactions. Therefore, the swap price will be an average of the forward prices that would prevail if each exchange were priced separately.
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Investment Risk Management–
Assignment Instructions
Evaluate Options, Futures, and Swaps
Examine derivative securities: options, futures, and swaps. Investors and financial
institutions that make use of these derivative securities to take positions are either
speculators or hedgers. Speculators are attempting to predict the direction of some
economic or market variable and generate gains on those predictions using
derivative securities. Hedgers will have a specific operational risk that could be
transferred using these derivative securities.
A call option is the right to buy an asset at an agreed-upon exercise price. A put
option is the right to sell an asset at a given exercise price. American-style options
allow exercise on or before the expiration date. European options allow exercise
only on the expiration date. Most traded options are American in nature. Options
are traded on stocks, stock indexes, foreign currencies, fixed-income securities,
and several futures contracts. Options can be used either to lever up an investor’s
exposure to an asset price or to provide insurance against volatility of asset
prices. Popular option strategies include covered calls, protective puts, straddles,
spreads, and collars.
Course Learning Outcomes
5.0. Compare and contrast values and risk Portfolio performance-international
diversification, and hedge funds
Support your paper with minimum of seven (7) scholarly resources. In addition to
these specified resources, other appropriate scholarly resources, including older
articles, may be included.
Length: 5-7 pages not including title and reference pages
Professor Overview: Futures, Swaps, and Risk Management
According to Bodie, Kane, and Marcus (2014), investors such as hedge funds use
hedging strategies to create market-neutral bets on perceived instances of relative
mispricing between two or more securities. They are not arbitrage strategies, but
pure plays on a particular perceived profit opportunity. Interest rate futures
contracts may be written on the prices of debt securities (as in the case of Treasurybond futures contracts) or on interest rates directly (as in the case of Eurodollar
contracts). Swaps, which call for the exchange of a series of cash flows, may be
viewed as portfolios of forward contracts. Each transaction may be viewed as a
separate forward agreement. However, instead of pricing each exchange
independently, the swap sets one “forward price” that applies to all of the
transactions. Therefore, the swap price will be an average of the forward prices that
would prevail if each exchange were priced separately.
Original Article
On derivatives use by equity-specialized
hedge funds
Received (in revised form): 9th August 2010
Jarkko Peltomäki
is an assistant professor of finance at the University of Vaasa. He is also an associate at Hedgehog Oy. His
research interests include derivatives, hedge funds, emerging markets and absolute investment strategies.
Correspondence: Jarkko Peltomäki, Department of Accounting and Finance, University of Vaasa, PO Box 700,
FIN-65101 Vaasa, Finland
ABSTRACT This study examines the performance and risk characteristics associated with
derivatives use by equity-specialized hedge funds. For equity options, the results provide
little evidence for profitability of the usage, but they are found to be associated with lower
risk. Equity options are likely to be used for option writing strategies given their negative
association with the skewness of hedge fund returns. For equity index futures, the results
show evidence that the use of equity index futures is associated with lower performance as
being substitute to share restrictions.
Journal of Derivatives & Hedge Funds (2011) 17, 42–62. doi:10.1057/jdhf.2010.21
Keywords: hedge funds; options; equity index futures
INTRODUCTION
As hedge funds are well able to use derivatives, it
is motivated to investigate their use. Derivatives
use by hedge funds is well investigated by Chen,1
but the study does not consider different asset
focuses of hedge funds. Considering the asset
focuses may be important as, for example, hedge
funds that focus on equity may use derivatives
very differently in comparison to hedge funds
that focus on fixed-income. This study focuses
on the use of derivatives for equity as the
primary asset class of a hedge fund, and examines
whether such use of equity options and equity
index futures is associated with their
performance and risk. The use of equity options
& 2011 Macmillan Publishers Ltd. 1753-9641
when the primary asset class of a hedge fund is
the same is hereafter defined as the equityspecialized use of options.
Focusing on equity-specialized use of options
is reasonable as it is considering the most
significant asset class of fund activities that makes
derivative use for the asset class relevant. The
reason to focus on equity-specialized use of
options follows the study by Aragon and
Martin.2 The study implies that hedge funds use
options for informed trading as options holdings
by hedge funds include more predictive power
than their stock holdings. The use of equity
index futures in turn is found to be important for
mutual funds by Frino et al 3 as the study suggests
Journal of Derivatives & Hedge Funds
www.palgrave-journals.com/jdhf/
Vol. 17, 1, 42–62
On derivatives use by equity-specialized hedge funds
that the futures may be used to manage fund
flows more efficiently. Hedge funds, contrary to
mutual funds, are well capable of restricting fund
flows, and in this way manage their liquidity
more efficiently. Restricting fund flows by hedge
funds is indeed found to be associated with their
abnormal returns, and thereby higher illiquidity
premium by Aragon.4 For hedge funds, the use
of equity index futures may be seen as a
substitute for restricting fund flows, and thus also
associated with lower abnormal performance in
accordance with lower illiquidity premium.
Taking the above reasoning together, it is
hypothesized that the asset-specialized use of
options (equity index futures) is associated with
higher (lower) performance. To test the
hypotheses above, a sample of 3403 live and dead
hedge funds collected from the Lipper TASS
database over the period 1994–2006 is used.
The results of the study present evidence that
the equity-specialized use of options can be
profitable when the performance of a hedge
fund is measured using the conventional Sharpe
ratio. However, the results for the impact of
options use by a hedge fund on its appraisal ratio,
which also counts for the exposure of hedge
funds to popular option writing strategies, do
not provide support for profitable use of options
by hedge funds. The use of equity index futures
is found to be associated with lower abnormal
performance consistent with the hypothesis that
these derivatives are associated with lower
illiquidity premium.
The remainder of this article is organized as
follows: the next section reviews the literature
on the derivatives use by hedge funds. The
section after that is for presentation of the
hypotheses of this study. The subsequent
section presents data and methodology of this
study. The penultimate section presents the
& 2011 Macmillan Publishers Ltd. 1753-9641
results of the study and the last section concludes
the study.
HEDGE FUNDS AND DERIVATIVE
USE
Aragon and Martin2 investigate common
equity and equity options use by hedge funds
considering their use for hedging. In their
study, they make use of a data set of Securities
Exchange Commission (SEC)-required
quarterly disclosures that covers the holdings
of 250 hedge fund advisors over the period
1999–2005. The study evinces that options
holdings by hedge funds are likely to have more
predictive power than stock holdings. In the
study, the greatest return predictability is found
for holdings of put options having high liquidity
in comparison to the underlying stock, in
addition to holdings of deep-out-of-the-money
options.
In the following study, Aragon and Martin5
make use of the same data source as in their
previous study over the period 1999–2006.
The results of the study imply that options use
is associated with relatively high subsequent
volatility on the underlying security, which can
be exploited by option trading. Subsequent
abnormal stock returns are also found to be
positively associated with call options holdings
and negatively associated with put holdings. This
result clearly suggests that hedge funds use
options in informed trading. Indeed, it is found
that by following hedge fund options holdings, it
is possible to earn annualized abnormal returns
of 14.8 per cent.
Chen1 focuses on investigating derivatives use
and risk taking of hedge funds by using a large
sample of hedge funds collected from the Lipper
TASS database. He also notices that 71 per cent
of hedge funds use derivatives, which is a
Journal of Derivatives & Hedge Funds
Vol. 17, 1, 42–62
43
Peltomäki
relatively high ratio in comparison to mutual
funds. In general, the results of the study suggest
that derivatives use by hedge funds is associated
with lower risk, and derivatives are used for risk
management. Yet, the implications of the study
differ significantly from the study Aragon and
Martin,5 which states ‘Overall the results
highlight a previously undocumented speculative
role of derivatives among professional investors’.
HYPOTHESIS DEVELOPMENT
Options use and hedge fund
performance
Consideration of the use of equity options by
hedge funds is interesting as there is evidence for
profitable option strategies, and particularly the
covered call strategy, which involves writing
call options against underlying equities
simultaneously (see Isakov and Morard;6
Whaley;7 McIntyre and Jackson 2007;8 Kapadia
and Szado 20079). Yet, implementing options
use in practice may be costly, as the study by
Bauer et al10 suggests that option trading has a
detrimental impact on the performance of
individual investors.
For hedge funds, Aragon and Martin2 find
that the option holdings include more predictive
power than their stock holdings, implying that
hedge funds use options for informed trading.
Informed trading by a hedge fund should follow
the asset specialization of a hedge fund. This
assumption should be credible, as Eichhold
et al11 show evidence for real estate investment
trusts (REIT) investment trusts that their
property specialization leads to outperformance.
There is also similar evidence for industry
specialization of mutual funds. Kacperczyk et al12
present evidence that industry specialization in
44
& 2011 Macmillan Publishers Ltd. 1753-9641
mutual fund industry may be beneficial. Chen13
also finds that hedge funds show market timing
ability in their focus market, implying that the
asset specialization of a hedge fund is beneficial.
In a close relation to the assumed performancespecialization relation, the results of Teo14
suggest that hedge funds focusing on the physical
presence of a hedge fund close to their market
leads to information advantage. The asset focus
of a hedge fund would similarly lead to
information advantage.
The above evidence supports the view that
asset specialization results in greater likelihood of
information advantage, and benefits from the use
of options are seen most of all when the
performance from the use of options for each
asset class is examined with respect to the asset
specialization of a fund.
In addition to the possibility of using options
for informed trading, options and other
derivatives can be used in various profitable
investment strategies such as volatility trading
and the covered call strategy. Some studies
suggest that derivative strategies can improve
portfolio performance (for example, Hill et al 15
and Guo16). These studies, together with the
possibility of using options for informed trading,
lead to the following hypothesis:
Hypothesis 1: The equity-specialized use of
options increases hedge fund performance.
Other considerations for options use
and hedge fund performance
It must be also considered that the use of options
by hedge funds may be associated with the risk of
a hedge fund, and the risk characteristics depend
on the strategy. If options are used to enhance
returns, it is likely to result in a fatter left tail of
Journal of Derivatives & Hedge Funds
Vol. 17, 1, 42–62
On derivatives use by equity-specialized hedge funds
the return distribution of a hedge fund. For
example, when the covered call strategy is used,
an investor gives up upside potential but receives
premium being left-skewed toward losses as the
downside potential of the strategy remains. In
general, writing options should result in more
negative skewness. Analogously, if options were
used to achieve protection, it would result in
lower premiums as a cost protection but also
higher skewness due to control of loss potential.
The former kind use of options is more likely for
hedge funds, as the results of Agarwal and Naik17
evince that option writing strategies resemble
hedge fund returns well.
The use of options also subsumes model
risk in addition to market risk. Green and
Figlewski18 emphasize the heavy use of
quantitative models in derivatives valuation and
risk management. Simulation run by the authors
evince that imperfect models and inaccurate
volatility forecasts are an additional risk for
option writers. This risk is especially relevant for
hedge funds that extensively use quantitative
models to perform their trading strategies.
Equity index futures and hedge fund
performance
Considering the use of other derivatives, the use
of equity index futures for cash management
becomes relevant. The first study implying the
use of this derivative type for cash management
is the study by Koski and Pontiff,19 which shows
evidence for mutual fund managers using
derivatives to alleviate the impact of new fund
inflows on fund risk. This result may also have
relevance for hedge fund performance, as the
study by Edelen20 relates fund flows negatively
to its alpha based on a rationale that new cash
force mutual fund managers to engage in
& 2011 Macmillan Publishers Ltd. 1753-9641
liquidity-motivated trading instead of informed
trading. When forced to engage in uninformed
trading, the abnormal returns of a fund may
suffer from trading costs. Equity index futures in
turn are highly liquid, and can be used to adjust
the exposure of the fund to the desired risk
under new cash flows. Frino et al 3 follow this
rationale when investigating the use of stock
index futures for the management of cash flows.
They find that derivative-based management can
prevent the negative impact of new cash on the
alpha of a mutual fund.
In the hedge fund industry, the use of
equity index futures may be a substitute for
share restrictions, which can be used to manage
liquidity efficiently. For instance, some less
promising hedge funds may lack bargaining power
to impose sufficiently restrictive redemption
policy to attract investors. These funds can then
use inferior financial instruments (regarding their
strategy) to manage liquidity. Share restrictions
that restrict fund flows are seen as proxies for
illiquidity premium (see Aragon4), and the use
of equity index futures would imply lower
illiquidity premium because the instrument itself
can be considered highly liquid. Low illiquidity
premium would result in lower measured
abnormal performance. These arguments lead
to the following hypothesis, which is sensible to
direct at hedge funds that focus on equity:
Hypothesis 2: The equity-specialized use of
equity index futures is related to lower
hedge fund performance.
DATA AND METHODOLOGY
The empirical analysis of this study begins with
univariate analysis of hedge fund risk and
Journal of Derivatives & Hedge Funds
Vol. 17, 1, 42–62
45
Peltomäki
performance on equity-specialized use of
options and index futures. Specifically, this
analysis tests whether risk and performance
of those hedge funds that employ this type of
derivatives use differ from the remaining funds
that have the same asset-specialization.
This study continues with the ordinary least
squares (OLS) analysis, which is used to provide
a detailed picture of the use of options and other
derivatives by equity-specialized hedge funds.
Other variables that may explain hedge-fund
performance and risk are controlled for and
presented in Table 1. The control variables
chosen are mainly followed by Chen’s1 study,
which presents evidence that higher minimum
investments, higher incentive fees, less restrictive
redemption policy, managerial ownership, the
absence of lockup periods, the absence of high
watermarks, and the use of auditing services are
associated with the use of derivatives of hedge
funds. The variables are presented in Table 1. In
addition, control dummy variables are used for
other asset focuses, the use of other assets, and
time-effect. The dummy variables for the timeeffect are annual taking the value of 1 if a hedge
fund is listed in the database at least 6 months
during the year.
The empirical model for the OLS analysis is
the following:
MEASUREji ¼ ai þ
N
X
lj CONTROLji
j¼1
þ
N
X
bj DERIVATIVEji þ ei ;
ð1Þ
variables for derivatives use include options use
for equity, fixed-income, commodity, currency.
The use of derivatives that have linear payoff
structures (swaps, futures and forwards) are used
as variables for each above-mentioned asset
classes. The use of warrants for equity and
fixed-income are used as separate variables. For
equities, TASS reports only the use of index
futures, not other equity futures.
Performance measures used in this study are
the Sharpe ratio, alpha and appraisal ratio of a
hedge fund. Risk measures used in this study are
the sample standard deviation, skewness, excess
kurtosis, and the Cornish–Fischer expansion of
the Modified Value-at-Risk (MVaR) measure.
S defines skewness and K defines excess kurtosis,
The Cornish–Fischer Expansion is defined as
follows:
1
CF ¼ zðaÞ þ z ðaÞ2 1 S
6
1
þ
z ðaÞ3 3zðaÞ K
24
1
2z ðaÞ 3 5zðaÞ S 2 ; ð2Þ
36
where z(a) defines the critical value
corresponding to the chosen confidence level,
and CF defines the critical value used in the
estimation of MVaR estimate. A confidence
interval of 99 per cent is used in the estimation
of the Cornish–Fischer expansion. The alpha is
estimated from a factor model that includes the
following explanatory variables:
j¼1
where MEASUREji defines a risk/performance
measure j of fund i; CONTROLji defines an
additional control variable j of fund i, and
DERIVATIVEji defines a dummy variable for
the use of a derivative j by fund i (1 if the
derivative is used, and 0 otherwise). The
46
& 2011 Macmillan Publishers Ltd. 1753-9641
1. the value-weight excess return on stocks
listed on the US stock markets;
2. Fama and Fench’s21 high-minus-low (HML)
factor (value anomaly);
3. Fama and Fench’s21 small-minus-big (SMB)
factor (size anomaly);
4. Carhart’s22 momentum factor;
Journal of Derivatives & Hedge Funds
Vol. 17, 1, 42–62
On derivatives use by equity-specialized hedge funds
Table 1: Variable definitions
Variables: Fund characteristics (dummy variables: 1 if yes)
LNSIZE
LNAGE
Natural logarithm of size
Natural logarithm of age
MFEE
IFEE
Management fee (%)
Incentive fee (%)
HWMARK
Dummy variable for the use of a high watermark
LEVERAGED
PERCAPITAL
Dummy variable for the use of leverage
Dummy variable for manager’s personal capital invested in the fund
LOCKUP
RESTRICTION
Lockup period (months)
The sum of payout and redemption periods (days, see Agarwal, Daniel and Naik 2009)
MIN
Minimum investment (USD)
AUDIT
OPENTOPUBLIC
Dummy variable to indicate whether a fund is audited (see Liang 2003)
Dummy variable to indicate whether a fund is open to public
OPENENDED
Dummy variable to indicate whether a fund is open ended
Variables: Derivatives use dummy variables (dummy va …
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