How to Price Hedge Funds: From Two- to Four-Moment CAPM

Abstract

Abstract The CAPM model is hard put to explain the superior performance of hedge funds in the past. We argue that the Markowitz mean-variance criterion underpinning the traditional CAPM may fail to capture systematic features characterizing hedge fund performance. Thus, we extend the two-moment market model to a higher-moment model to accommodate coskewness and cokurtosis. The higher-moment approach is more appropriate for capturing the non-linear relation between hedge fund and market returns and accounting for the specific risk-return payoffs of each hedge fund investment strategy. The key result is that the use solely of the two-moment pricing model may be misleading and may wrongly indicate insufficient compensation for the investment risk. First Version: July 23, 2002 This Version: July 14, 2005 JEL Classification : C29; G12 Keywords : Hedge Funds, Higher Moments, Skewness, Kurtosis, Coskewness, and Cokurtosis. α Angelo Ranaldo, Swiss National Bank, Research Department, Borsenstrasse 15, P.O. Box 2800, Zurich, Switzerland. E-mail: angelo.ranaldo@snb.ch, Phone: ++41.44.6313826, Fax: ++41.44.6313901.