Standard Hedging Research Articles

Interpreting institutional investment activity as a markov process: A stock recommender

Institutional investors like hedge funds are particularly resilient in times of volatility, primarily due to their access to a slew of complex trading strategies and extensive research capabilities; both of which are generally outside the reach of common investors. Fortunately, the U.S. Securities and Exchange Commission has mandated that large institutional investors publicly disclose the positions held by them at the end of a quarter, within the following 45 days. We then ask the question “Given our access to snapshots of positions held by large investors, can we extract alpha by approximating their aggregate behaviour?” In this paper, we introduce a stock recommendation model driven by the aggregate behaviour of institutional investors. We interpret stocks as the states of a Markov chain. The corresponding state transition matrix is defined based on the aggregate behaviour of investors. By designing the transition matrix to hold for aperiodicity and irreducibility, the steady state distribution of this chain is treated as a ranked list of stocks. We build a long only, equally weighted portfolio of stocks to trade using these recommendations. We observe that the returns on this portfolio beat existing models in the literature, and standard hedge fund indices both in terms of annualised returns and Sharpe ratio.

Hedging local currency risk with precious metals

Precious metals are popular instruments for hedging local currency risk. Most precious metals are priced in US dollars, which is a single-currency numéraire. The numéraire of a precious metal can easily be changed, which allows investors to choose their own local currency as the precious metal’s numéraire and subsequently use it to hedge their own local currency risk. In this paper, we decompose the standard hedge ratio into two parts, namely, a precious-metal hedge ratio and a local-currency hedge ratio. We consider three main precious metals, namely, gold, silver and platinum, from the beginning of 1990 to the end of 2019 to hedge local currency risk for individual G10 currencies. Over the full sample, we find that all standard hedge ratios are negative for all combinations of currencies and precious metals. However, the negativity is driven by the precious metal’s numéraire, rather than the precious metal.

Target tracking based on standard hedging and feature fusion for robot

PurposeVisual tracking technology enables industrial robots interacting with human beings intelligently. However, due to the complexity of the tracking problem, the accuracy of visual target tracking still has great space for improvement. This paper aims to propose an accurate visual target tracking method based on standard hedging and feature fusion.Design/methodology/approachFor this study, the authors first learn the discriminative information between targets and similar objects in the histogram of oriented gradients by feature optimization method, and then use standard hedging algorithms to dynamically balance the weights between different feature optimization components. Moreover, they penalize the filter coefficients by incorporating spatial regularization coefficient and extend the Kernelized Correlation Filter for robust tracking. Finally, a model update mechanism to improve the effectiveness of the tracking is proposed.FindingsExtensive experimental results demonstrate the superior performance of the proposed method comparing to the state-of-the-art tracking methods.Originality/valueImprovements to existing visual target tracking algorithms are achieved through feature fusion and standard hedging algorithms to further improve the tracking accuracy of robots on targets in reality.

Portfolio Strategies to Track and Outperform a Benchmark

I investigate the question of how to construct a benchmark replicating portfolio consisting of a subset of the benchmark’s components. I consider two approaches: a sequential stepwise regression and another method based on factor models of security returns’ first and second moments. The first approach produces the standard hedge portfolio that has the maximum feasible correlation with the benchmark. The second approach produces weights that are proportional to a “signal-to-noise” ratio of factor beta to idiosyncratic volatility. Using a factor model of securities returns allows the use of a larger number of securities than the number of time periods used to estimate the parameters of the factor model. I also consider a second objective that maximizes expected returns subject to a target tracking error variance. The security selection criterion naturally extends to the product of the information ratio and the signal-to-noise ratio. The optimal tracking portfolio is either a one-fund or a two-fund portfolio rule consisting of the optimal hedging portfolio, the tangent portfolio or the global minimum variance portfolio, depending on what constraints are imposed on the objective function. I construct buy-and-hold replicating portfolios using the algorithms presented in the paper to track a widely followed stock index with very good results both in-sample and out-of-sample.

Cross-situational Consistency of Female Politicians’ Language Use

This article seeks to study political discourses of American female politicians, specifically Madeleine Albright, the first female United States Secretary of State in the history of the United States of America, from 1997 to 2001, Condoleezza Rice, the 66th United States Secretary of State, and Hillary Clinton, the 67th United States Secretary of State. Different in age, ethnicity, political views, educational and social backgrounds, they reveal that in order to succeed in the political arena, women are bound to hide their female personality. Examples in question are Madeline Albright and Condoleezza Rice, recurrent users of such male discursive features as rhetorical questions, logical order of arguments, conceptual metaphors of war, sports, and hunting. Gender-marked female discourse is characterized by hesitation, use of standard speech, cognitive, social words, and hedges. Research shows that Hilary Clinton is a typical example of the female-marked political discourse. This has enabled her to pursue, among others, a feminist agenda, which has proved an efficient communicative tactic. Drawing on the socialization specifics of Albright, Rice, and Clinton, the paper explains why Albright and Rice tend to have a male-marked discourse and Clinton a female-marked discourse, as the first female Secretary of State, Albright simply had no female role models, with only male predecessors before her. She seeks to make her speech as neutral as possible, just at times exploiting female discursive patterns. Condoleezza Rice, Albright’s successor, uses characteristically male discourse the most. It can be attributable to the fact that she belongs to two ‘minority’ groups: women and African Americans. Sounding femalish might have weakened her chances to stay the strong Secretary of State that the geopolitical situation would demand. It is noteworthy that female politicians can, or have to, switch between male-marked and female-marked discourses in order to achieve certain goals and preserve their current status.

Testing derivatives pricing models under higher-order moment swaps

Purpose This paper aims to test three parametric models in pricing and hedging higher-order moment swaps. Using vanilla option prices from the volatility surface of the Euro Stoxx 50 Index, the paper shows that the pricing accuracy of these models is very satisfactory under four different pricing error functions. The result is that taking a position in a third moment swap considerably improves the performance of the standard hedge of a variance swap based on a static position in the log-contract and a dynamic trading strategy. The position in the third moment swap is taken by running a Monte Carlo simulation. Design/methodology/approach This paper undertook empirical tests of three parametric models. The aim of the paper is twofold: assess the pricing accuracy of these models and show how the classical hedge of the variance swap in terms of a position in a log-contract and a dynamic trading strategy can be significantly enhanced by using third-order moment swaps. The pricing accuracy was measured under four different pricing error functions. A Monte Carlo simulation was run to take a position in the third moment swap. Findings The results of the paper are twofold: the pricing accuracy of the Heston (1993) model and that of two Levy models with stochastic time and stochastic volatility are satisfactory; taking a position in third-order moment swaps can significantly improve the performance of the standard hedge of a variance swap. Research limitations/implications The limitation is that these empirical tests are conducted on existing three parametric models. Maybe more critical insights could have been revealed had these tests been conducted in a brand new derivatives pricing model. Originality/value This work is 100 per cent original, and it undertook empirical tests of the pricing and hedging accuracy of existing three parametric models.

Focusing on Patients' Existing Resources and Strengths in Cognitive-Behavioral Therapy and Psychodynamic Therapy: A Systematic Review and Meta-Analysis.

Objectives: Integrating a stronger focus on patients' existing strengths in traditional psychotherapy approaches is suggested by recent developments in psychological science, positive psychology, and psychotherapy research. However, the empirical status of treatments focusing on patients' existing strengths is unclear. The aim of this study was to conduct a systematic review (PROSPERO registration CRD42017054362) of studies on adaptations of traditional treatment approaches (e. g., cognitive-behavior therapy or psychodynamic therapy) explicitly focused on using patients' existing resources and strengths (hereafter, resource-focused treatments; RFT). Methods: Extensive systematic literature search yielded k = 11 treatment comparisons from 10 studies contrasting RFTs with either an alternative psychotherapeutic approach or wait list. Effect sizes controlling for pre-treatment differences (gPPWC) and standard Hedges's g effect sizes (gPOWC) were aggregated with random-effects methods Results: Across 8 direct comparisons, RFTs were superior to other psychotherapeutic approaches, as indicated by small to moderate (gPPWC = -0.349, 95 % CI -0.576, -0.122, p = .003, I2 = 46.50 %) and small effect sizes (gPOWC = -0.190, 95 % CI -0.355, -0.025, p = .024, I2 = 0.00 %) in favor of RFTs. Sensitivity analyses corroborated results. Many included studies were characterized by limited sample size, risk of bias or researcher allegiance. Conclusions: This meta-analysis showed preliminary evidence for the benefits of RFTs and suggests an intensification of further research efforts. The evidence was most convincing for hypnotherapeutic-systemic interventions as an add-on for cognitive-behavioral therapy.

'Exchange Rate Risk' within the European Monetary Union? Analyzing the Exchange Rate Exposure of German Firms

In this paper we show that inflation differentials among the countries in the European Monetary Union (EMU) are an economically significant risk to German firms, which make up the largest economy in the EMU. This risk can be interpreted as real “exchange rate exposure” resulting from trade within the euro area. Actually, we find that this EMU exposure is nearly as high as the standard exchange rate exposure caused by trade with non-EMU countries. Moreover, our analysis shows that many of the conventional factors that drive firm-specific exchange rate risk, such as size, debt ratio, asset turnover and foreign business activity, also determine EMU exposure in an economically meaningful way. However, EMU exposure challenges firms’ risk management, particularly as it cannot be reduced by standard financial hedging instruments such as currency derivatives.

Asset price bubbles and risk management

The purpose of this paper is to review the literature on asset price bubbles to study the impact that the existence of bubbles has on standard risk management methodologies. In the presence of asset price bubbles, a trader’s optimal portfolio holdings decrease and a financial institution’s optimal level of equity capital needs to be increased relative to a market without bubbles. Further, risk-neutral valuation for derivatives is often incorrect and the standard hedging techniques are suboptimal.

From Utility Indifference Pricing to Risk Premium Pricing for a Contingent Claim on a Non-Tradable Asset

Pricing a contingent claim on a non-tradable asset (e.g. a management warrant package in an LBO) cannot be done with standard hedging based option pricing theory. Common alternatives are utility indifference pricing, suggested by various authors, or risk premium pricing (using the option pricing methodology with the asset drift modified for a risk premium), often favored by practitioners. The purpose of this note is to point out that the two approaches are in fact conceptually equivalent, in the sense that the utility function risk aversion in the first method can be mapped into a risk premium in the second method.

Optimal hedging ratio modeling using interday and intraday risk estimation: Moving window regression vs. cointegration approach

We considered the problem of choosing optimal hedging ratio taking into account interday and intraday return de- composition. It was shown that the standard hedging approach which uses only close prices (i.e. daily returns) is inefficient in comparison with hedging strategy based on open and close prices, i.e. when differentiating hedging ratio for interday and intra- day periods. Results are confirmed both by applying Moving Window Regression and Error Correction Model for major world indexes for 1992-2012.

Hedging Efficiently Under Correlation

We show that when a derivative portfolio has different correlated underlyings, hedging using classical greeks (first-order derivatives) is not the best possible choice. We first show how to adjust greeks to take correlation into account and reduce P&L volatility. Then we embed correlation-adjusted greeks in a global hedging strategy that reduces cost of hedging without increasing P&L volatility, by optimization of hedge re-adjustments. The strategy is justified in terms of a balance between transaction costs and risk aversion, but, unlike more complex proposals from previous literature, it is completely defined by observable parameters, geometrically intuitive, and easy to implement for an arbitrary number of risk factors. We test our findings on a CVA hedging example. We first consider daily re-hedging: in this test correlation-adjusted greeks allow to reduce P&L volatility by more than 30% compared to standard deltas. Then we apply our general strategy to a context where a CVA portfolio is exposed to both credit and interest rate risk. The strategy keeps P&L volatility in line with daily standard delta hedging, but with massive cost-saving: only six rebalances of the illiquid credit hedge are performed, over a period of six months.

An endogenous volatility approach to pricing and hedging call options with transaction costs

Standard delta hedging fails to exactly replicate a European call option in the presence of transaction costs. We study a pricing and hedging model similar to the delta hedging strategy with an endogenous volatility parameter for the calculation of delta over time. The endogenous volatility depends on both the transaction costs and the option strike prices. The optimal hedging volatility is calculated using the criterion of minimizing the weighted upside and downside replication errors. The endogenous volatility model with equal weights on the up and down replication errors yields an option premium close to the Leland [J. Finance, 1985, 40, 1283–1301] heuristic approach. The model with weights being the probabilities of the option's moneyness provides option prices closest to the actual prices. Option prices from the model are identical to the Black–Scholes option prices when transaction costs are zero. Data on S&P 500 index cash options from January to June 2008 illustrate the model.

Benchmark replication portfolio strategies

We propose a novel approach to the benchmark replication problem which uses a minimum tracking error variance as an objective subject to a target expected outperformance. When no budget constraint is imposed on the replicating portfolio, the solution involves that standard hedge portfolio and the tangent portfolio constructed from the replicating securities. In the presence of a budget constraint as well, the solution also includes the minimum variance portfolio constructed from the replicating securities. We implement our theoretical results using recent data for three widely followed US stock indices with very good out-of-sample performance.

Hedge fund contagion and risk-adjusted returns: A Markov-switching dynamic factor approach

We provide an empirical analysis of two important phenomena influencing the hedge fund industry—contagion and time variation in risk adjusted return (alpha)—in a flexible unified framework. After accounting for standard hedge fund pricing factors, we quantify the common latent factor in hedge fund style index returns and model its time-varying behavior using a dynamic factor framework featuring Markov regime-switching. We find that three regimes—crash, low mean and high mean—are necessary to provide a complete description of joint hedge fund return dynamics. We also document significant time variation in the alpha generating ability of all hedge fund investment styles. The period following the stock market crash of 2000 is dominated by the persistent low return state while the long bull market of 1990s is associated with the strongest performance of the industry generating high positive returns. We also investigate drivers of the regime shifts in the common latent pricing factor and find that both flight to safety and large funding liquidity shocks play an important role in explaining the abrupt shift of the common factor to the crash state. ► We quantify the common latent pricing factor in hedge fund style index returns. ► Our dynamic factor model incorporates Markov regime-switching. ► Three regimes—crash, low-mean and high mean—describe latent factor dynamics. ► Significant time variation in the risk-adjusted return (alpha) generating ability ► Both flight to safety and funding liquidity play an important role in contagion.

Hedge Fund Replication: The Asymmetric Way

This article introduces the concept of asymmetric hedge fund replication based on the risk factor model approach. The presented methodology is founded on downside risk management and offers an enhancement of existing hedge fund replication techniques. From a conceptual perspective, asymmetric hedge fund replication enables investors to achieve superior risk-adjusted performance in cases in which precise target tracking is not imperative. Along with the introduction of the asymmetric hedge fund replication, a new classification framework of replication methodologies is discussed, in which the replication objective is the center point. The out-of-sample performance of the presented approach is examined in an exemplary empirical replication of two major hedge fund sector indices with a popular factor model setting used in previous studies. Finally, aMonte Carlo study is conducted in which the authors simulate hedge fund returns and examine the out-of-sample performance. The comparison to standard hedge fund replication reveals the characteristic risk-return profile of the asymmetric approach. In sum, the risk-adjusted performance increases at the cost of target replication accuracy.The results of the short study support all aspects of the authors’ conceptual hypothesis and justify more extensive investigations. <b>TOPICS:</b>Real assets/alternative investments/private equity, factor-based models, simulations, performance measurement

Benchmark Replication Portfolio Strategies

We propose a novel approach to the benchmark replication problem which uses a minimum tracking error variance as an objective subject to a target expected outperformance. When no budget constraint is imposed on the replicating portfolio, the solution involves that standard hedge portfolio and the tangent portfolio constructed from the replicating securities. In the presence of a budget constraint as well, the solution also includes the minimum variance portfolio constructed from the replicating securities. We implement our theoretical results using recent data for three widely followed US stock indices with very good out-of-sample performance.

Assessing the influence of spot price predictability on electricity futures hedging

A common feature of energy prices is that spot price changes are partially predictable due to weather and demand seasonalities. This paper follows the Ederington and Salas (2008) framework and considers the expected change in spot prices when minimum variance hedge ratios are computed. The poor effectiveness of hedging strategies obtained in previous studies on electricity was because the standard hedging approach underestimates the effectiveness of hedging. In the empirical study made in this paper, weekly spot price risk is hedged with weekly futures in the Nord Pool electricity market. In this case, the optimal selection of the futures contract may produce risk reductions whose values vary between 60% and 80% – depending on the hedging duration (one to three weeks) and the analysed sub-period (in-sample and out-of-sample sub-periods).

On Hedge Fund Structures: Improving AllocationModels for Illiquid Investments

In the 2000s large investment banks and hedge funds became a major source of capital for start up firms and private equity deals. However, the standard hedge fund structure led to the largest bankruptcy rate in investment banks since the Great Depression. The hedge funds that were involved in the private equity business have also had trouble due to the lack of leverage capital resulting in multiple prime brokers that provided the leverage becoming insolvent. The hedge funds have also had net redemptions as investors try to redeem their shares in the fund. Many funds are currently invoking a clause in the fund documents that limits the amount of net redemptions. The authors review the standard hedge fund structure, then modify it utilizing a side pockets. <b>TOPICS:</b>Private equity, legal/regulatory/public policy, financial crises and financial market history

An Endogenous Volatility Approach to Pricing and Hedging Call Options with Transaction Costs

Standard delta hedging fails to exactly replicate a European call option in the presence of transaction costs. We study a pricing and hedging model similar to the delta hedging strategy with an endogenous volatility parameter for the calculation of delta over time. The endogenous volatility depends on both the transaction costs and the option strike prices. The optimal hedging volatility is calculated using the criterion of minimizing the weighted upside and downside replication errors. The endogenous volatility model with equal weights on the up and down replication errors yields an option premium close to the Leland (1985) heuristic approach. The model with weights being the probabilities of the option's moneyness provides option prices closest to the actual prices. Option prices from the model are identical to the Black-Scholes option prices when transaction costs are zero. Data on S\&P 500 index cash options from January to June 2008 illustrate the model.