EDHEC Publications
Where Experience Matters: Asset Allocation and Asset Pricing with Opaque and Illiquid Assets
2015
Alternative assets, such as private equity, hedge funds, and real assets, are illiquid and opaque, and thus pose a challenge to traditional models of asset allocation. In this paper, we study asset allocation and asset pricing in a general-equilibrium model with liquid assets and an alternative risky asset, which is opaque and incurs transaction costs, and investors who differ in their experience in assessing the alternative asset. We find that the optimal asset-allocation strategyof the relatively inexperienced investors is to initially tilt their portfolio away from the alternative asset...
Crude Oil Futures Markets: Are the Benefits of "Roll Yield" Real?
2014
This paper examines whether roll yield is still a useful concept in evaluating crude oil futures markets. This is a timely question because of (a) scepticism on the benefits of roll yield; and (b) the dramatic drop in oil prices had led investors to question whether crude-oil-futures positions deserve a role in a diversified investment portfolio.
Equity Portfolios with Improved Liability-Hedging Benefits
2014
This paper extends the LDI paradigm by assessing whether LDI solutions can be enhanced by the design of performanceseeking equity benchmarks with improved liability-hedging properties. We confirm this intuition and show that improving hedging characteristics of the performance portfolio generates welfare gains unless this improvement comes at an exceedingly large opportunity cost in terms of performance — a result that we call the fund interaction theorem.
How Much Construction Risk do Sponsors Take in Project Finance?
2014
Using new data, this paper shows that construction risk in infrastructure project finance is well-managed and that project sponsors face very little construction risk compared to the well-documented, systematic and very large cost overruns found in traditional infrastructure project procurement. We know from the project management literature that construction risk is significant in public infrastructure projects delivered through traditional procurement methods. We also know that, when similar projects are procured using project financing, construction risk is passed on through date-certain,...
The Impact Of Risk Controls And Strategy-Specific Risk Diversification On Extreme Risk
2014
To overcome the deficiencies of cap-weighted indices, smart beta strategies have been proposed. They employ weighting schemes that deviate from cap-weighting, deal with the problem of concentration and allow for a flexible index construction process in which the index can be tilted to better rewarded factors. Along with the better risk-adjusted performance, however, investors in smart beta strategies are exposed to additional risks.The goal of this paper is to check empirically if controlling the exposure to some risks such as country, sector, tracking error, or sample risk does not increase...
Unlisted Infrastructure Debt Valuation & Performance Measurement: Theoretical Framework and Data Collection Requirements
2014
Building on advanced and robust credit risk modelling and private debt valuation techniques, this paper focuses on delivering those performance measures that are the most relevant to investors at the strategic asset allocation level, and to prudential regulators for the calibration of risk weights. It provides a implementable framework for the formation of risk and return expectations in illiquid infrastructure debt, and also defines the most parsimonious data input requirements. Hence, we can realistically expect to deliver these performance measures at a minimal data collection cost.
Superannuation V2.0: Towards The Next Generation Of Pension Funds In Australia
2014
This paper discusses potential improvements to the design of retirement products in the Superannuation system, including the impact of transparency and governance on the credibility of the pension investment solutions, the role of market structure and competition on the creation of adequate investment options, the role of asset allocation and risk management in the determination of optimal pension products including default options, and the matter of the horizon of lifecycle investment solutions in a country with rising longevity.
Dynamic Allocation Strategies for Absolute and Relative Loss Control
2014
The maximum drawdown control strategy dynamically allocates wealth between cash and a risky portfolio, keeping losses below a chosen pre-defined level. This paper introduces variations of the strategy, namely the excess drawdown and the relative drawdown control strategies. The excess drawdown control is a more flexible strategy that can cope with common (re)allocation restrictions such as lock-up periods, cash bans or liquidity constraints through an implementation with a hedging overlay. The relative drawdown control strategy is adapted to contexts in which investors seek to limit benchmark...
Risk Allocation, Factor Investing And Smart Beta: Reconciling Innovations In Equity Portfolio Construction
2014
This publication argues that current smart beta investment approaches only provide a partial answer to the main shortcomings of capitalisation-weighted (cap-weighted) indices, and develops a new approach to equity investing referred to as smart factor investing. It provides an assessment of the benefits of simultaneously addressing the two main shortcomings of cap-weighted indices, namely their undesirable factor exposures and their heavy concentration, by constructing factor indices that explicitly seek exposures to rewarded risk factors while diversifying away unrewarded risks. The results...
Should A Skeptical Portfolio Insurer Use An Optimal Or A Risk-Based Multiplier?
2014
Following recent evidence of out-of-sample stock market return predictability, the authors aim to evaluate whether the potential benefits suggested by asset allocation theory can actually be captured in the real world using expected return estimates from a predictive system. The question is addressed in the context of an investor maximising the long-term growth rate of wealth under a maximum drawdown constraint, and comparing the optimal strategy using the predictive system with a similar risk-based allocation strategy, independent of expected return estimates. More...
Tail Risk Of Smart Beta Portfolios: An Extreme Value Theory Approach
2014
This paper studies the in-sample extreme risk of smart beta portfolios using the GARCH-EVT model. To validate the in-sample approach, we back-tested the methodology on smart beta indices constructed from long-term US data spanning 40 years and found that the methodology is robust and reliable. The VaR- and CVaR-based tests for the case of 1% tail probability indicated that, with a couple of exceptions, the model is statistically acceptable for all portfolios for both the left and the right tail.
A Predictive System with Heteroscedastic Expected Returns and Economic Constraints
2014
We propose a variation of a predictive system that incorporates two (additional) economically motivated assumptions about the dynamics of expected returns, namely 1) their positivity, and 2) a time-varying volatility correlated with economic regimes. The implications of the modified system are consistent with well established empirical facts of stock returns, in particular, the simpler version of the modified system without predictors can explain the well documented countercyclicality of the dividend-price ratio’s predictive power.
Catastrophe Bonds: An Important New Financial Instrument
2014
This paper describes key features of catastrophe bonds or CAT bonds. CAT bonds are issued by a reinsurer for indemnification against tail risks of a major disaster such as a hurricane, earthquake, or pandemic. The money with which investors purchase CAT bonds is deposited in safe securities such as US Treasuries. The investor then receives interest on these securities plus premiums paid regularly by the issuer of the bond. If a “triggering event” (the covered catastrophe) occurs before maturity the bond may “default” in that investors may not be returned part or all of their principal, which...
Equal or Value Weighting? Implications for Asset-Pricing Tests
2014
Does the choice of weighting scheme used to form test portfolios influence inferences drawn from empirical tests of asset pricing? To answer this question we first show that, with monthly rebalancing, an equal-weighted portfolio outperforms a value-weighted portfolio in terms of total mean return, four-factor alpha, and Sharpe ratio. We then explain that this outperformance is partly because the equal-weighted portfolio has higher exposure to systematic risk factors; but, a considerable part (42%) of the outperformance comes from the difference in alphas, which is a consequence of the...
Global Style Portfolios Based on Country Indices
2014
Factor portfolios created by dynamically weighting country indices generated significant global market adjusted returns over the last 30 years. The comparison between stock and country based factor portfolios suggests that country based value, size and momentum factor portfolios implemented through index futures or country ETFs capture a large part of the return of stock based factor strategies. Given the complex issues and costs involved in implementing stock based factor strategies in practice, country based factor strategies offer a viable alternative.
Benchmarking Long-Term Investment in Infrastructure: Objectives, Roadmap and Recent Progress
2014
This paper proposes an approach to benchmark long-term investments in infrastructure, where long-term investment simply refers to any unlisted and illiquid asset. It first highlights the reasons why benchmarking long-term infrastructure investments has become a sine qua non to match the supply and demand of long-term capital, improve asset allocation outcomes for investors and support the development of the economy.
A Proposal for an Interest Rate Dampener for Solvency II to Manage Pro-Cyclical Effects and Improve Asset-Liability Management
2014
The aim of this study is to propose the introduction of a Dampener adjustment in the risk measure for bond instruments — which takes economic cycles into account. Firstly, we have revisited the regulator’s chosen method for measuring bond risk (bond Solvency Capital Requirement), highlighting the main limitations, and thereby showing the need for an equity-type dampener within the regulatory bond risk measure. Secondly, we have built a proposal of a Dampener model based on a three-factor mean reversion which reduces the pro-cyclical effect of the Solvency II standard formula.
Why Some Futures Contracts Succeed and Others Fail: A Survey of Relevant Research
2014
Why do some futures contract succeed and others fail? Numerous researchers have provided case studies on both new and existing futures contracts, so this paper is fortunate to have a wealth of material from which to directly cite. Accordingly, this article will survey a number of textbooks, trade publications, academic papers, and think-tank articles from which one can distill lessons from over 160 years of (largely) U.S. experience with commodity trading. It turns out that even though the U.S. futures markets have evolved in a trial-and-error fashion, one can nonetheless identify the key...
OPEC Spare Capacity and the Term Structure of Oil Futures Prices
2014
This article looks into whether we can parsimoniously explain whether holding long futures positions in crude oil is a wise decision or not. It turns out that whether OPEC spare capacity is at comfortable levels or not would have been very helpful in making this decision, at least since the 1990s. Given the strength of this historical relationship, we can then speculate that it may be wise to examine current levels of OPEC spare capacity before deciding upon structural crude oil futures positions.
On the Rate of Return and Valuation of Non-Conventional Projects
2014
This paper provides a solution for evaluating non-conventional projects, firstly showing that the well-known modified internal rate of return does not correctly answer what investors want to measure. Even if one correctly uses the net present value criterion for capital budgeting, we show that it fails for non-conventional projects. Our contribution is thus twofold: To yield the correct rate of return for non-conventional projects and to allow practitioners to correctly calculate comparable net present values to take correct investment decisions.
Quantitative Portfolio Construction and Systematic Trading Strategies using Factor Entropy Pooling
2014
The Entropy Pooling approach is a versatile theoretical framework to process market views and generalised stress-tests into an optimal “posterior” market distribution, which is then used for risk management and portfolio management. Entropy Pooling can be implemented non-parametrically or parametrically. The non-parametric implementation with historical scenarios is more suitable for risk management applications. Here we introduce the parametric implementation of Entropy Pooling under a factor structure, which we name Factor Entropy Pooling. The factor structure reduces the dimension of the...
The Importance of the Structural Shape of Crude Oil Futures Curves
2014
In the past, one could confidently discuss how crude oil futures contracts typically trade in “backwardation.” By backwardation, one means that a near-month futures contract trades at a premium to deferred-delivery futures contracts. For example, Litzenberger and Rabinowitz (1995) pointed out that the NYMEX West Texas Intermediate (WTI) crude oil futures contract’s front-to-back futures spreads were backwardated at least 70% of the time between February 1984 and April 1992. This pattern was so persistent that these authors theorised why this should be the typical shape of the crude oil...
The History of Financial Derivatives: A 2-Part Feature
2014
This 2-part series discusses the emergence of financial derivatives after the collapse of the Bretton Woods accord in 1971. In Part 1, the paper explains the concepts that enabled financial derivatives markets to flourish, focusing on the required mathematical concepts. Part 2 continues with enumerating the business models that have been employed by successful commercial participants in the financial derivatives arena. A revisited version of this paper was published in the November/December 2015 issue of Corporate Finance Review.
Towards Conditional Risk Parity — Improving Risk Budgeting Techniques in Changing Economic Environments
2014
This paper introduces three distinct conditional risk parity strategies, explicitly designed to optimally respond to changes in state variables that have been used in the literature as proxies for the stochastically time-varying opportunity set. In an empirical analysis, the paper documents the superiority in various economic regimes of such conditional risk parity strategies with respect to standard unconditional risk parity techniques.
The Fund of Hedge Fund Selection Puzzle: A Pragmatic Approach to Identify the X-Factor
2014
We use the regime switching approach introduced in Pelletier (2006), and adapted by Giamouridis and Vrontos (2007) to the context of hedge fund portfolios, to design a new tactical style allocation factor. We then propose to leverage on this factor to identify fund of hedge fund managers who turn out to be good at capturing the upside while controlling for the downside risk. By so doing, we provide investors with a pragmatic though robust approach to address the fund of hedge fund selection puzzle.
Growth Optimal Portfolio Insurance For Long-Term Investors
2014
We solve for the growth-rate optimal multiplier of a portfolio insurance strategy in the general case with a locally risky reserve asset and stochastic state variables. The level of the optimal time-varying multiplier turns out to be lower than the standard constant multiplier of CPPI for common parameter values. As a consequence the outperformance of the growth-optimal portfolio insurance strategy (GOPI) does not come with higher risk. A revisited version of this paper is forthcoming in the Journal of Investment Management.
Tail Risk Of Equity Market Indices: An Extreme Value Theory Approach
2014
Value-at-risk (VaR) and conditional value-at-risk (CVaR) have become standard choices for risk measures in finance. Both VaR and CVaR are examples of measures of tail risk, or downside risk, because they are designed to exhibit a degree of sensitivity to large portfolio losses whose frequency of occurrence is described by what is known as the tail of the distribution: a part of the loss distribution away from the central region geometrically resembling a tail. In practice, VaR provides a loss threshold exceeded with some small predened probability, usually 1% or 5%, while CVaR measures the...
Optimising The Compression Cycle: Algorithms For Multilateral Netting In OTC Derivatives Markets
2014
This paper proposes and analyses a set of optimal compression algorithms for fungible derivatives. It finds that they all perform extremely well across a range of criteria and discusses their relative attributes. Although the focus is on the CDS market, the methods analysed here can be applied to other OTC derivative markets. If done optimally, compression is an effective counterparty risk mitigation technique that should be encouraged by regulators, especially as the benefits increase dramatically with the number of participants.
Index Transparency - A Survey Of European Investors' Perceptions, Needs And Expectations
2014
Between August and November 2013, EDHEC-Risk Institute surveyed 109 institutional investors from across Europe, including Europe’s largest pension and reserve funds, insurance and provident institutions and their asset management subsidiaries, to document their expectations and requirements with respect to index transparency and take stock of their perceptions of, and the extent of their support for, the main directions of the ongoing regulatory debate on indexing and financial benchmarks.
The EDHEC European ETF Survey 2013
2014
The latest edition of the European ETF Survey, which presents the results of a comprehensive survey of 207 European ETF investors, analyses the current practices and perceptions among ETF users in Europe and intends to shed light on trends within the European ETF market by comparing our results with those of our previous surveys. This year, the survey results show that ETF investors are still looking to increase or at least to maintain their use of ETFs and have a more favourable outlook on their use of alternative indexing products.
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About EDHEC
Operating from campuses in Lille, Nice, Paris, London and Singapore, EDHEC is one of the world’s top 15 business schools. Fully international and directly connected to the business world, EDHEC commands a strong reputation for research excellence and the ability to train entrepreneurs and managers capable of breaking new ground. EDHEC functions as a genuine laboratory of ideas and produces innovative solutions valued by businesses. The School’s teaching is inspired by its research work and a focus on “learning by doing”, all with the aim of equipping people with the skills to succeed in business.
